One of my close friends, a banker with an academic background, spent more than a year and a substantial amount of money developing a very sophisticated empirical asset allocation model. Alas, there were nowhere near enough clients to reward his personal and financial investment.
It was therefore with well-focused curiosity and heightened expectations that I approached this work by John Campbell and Luis Viceira.
I did not allow myself to be put off by the context of the study: "One of the most important decisions many people face is the choice of a portfolio of assets for retirement savings." That would have been of little consequence in Europe until not too long ago. But the increased reliance of individuals on defined-contributions pension schemes and the near-demise of defined-benefits schemes has made this topic of great relevance in Europe, almost as much as it always was in the US. I agree with the authors that "until recently... empirical work on long-term portfolio choice has lagged far behind the theoretical literature".
They claim that "one reason for the slow development of the field has been the difficulty of solving [Robert] Merton's intertemporal model" and they propose to deal with the problem thanks to numerical solutions made possible by increased availability of computing power, some new closed-form solutions and approximate analytical solutions "based on perturbations of known exact solutions, so they are accurate in a neighbourhood of those solutions".
But this approach produces a feeling of déja vu. Many academics in the field of finance wishing to "monetise" their knowledge through empirical applications sellable to Wall Street or the City have walked that particular path. However, I do not think that cashing in on their knowledge was at all the motivation of these two authors. Otherwise, they would not have supplied 15 pages of academic references, nor would they have invested a huge amount of time and effort in confronting step-by-step the relevant theoretical literature. Furthermore, they would not have chosen such a fragmented field as that covered by financial planners. Instead, they would have dealt with the issues of interest to investment bankers, such as the asset allocation problems of individuals of ultra-high net worth.
While accepting therefore the sanctity of the motivation of the authors, one has nevertheless to question their understanding of the real value of an empirical framework in the limitations they are forced to set.
Real-life long-term investors in occupational jobs are concerned with transaction costs and with taxation, and have a significant portion of their savings invested in real estate. But these are listed as exclusions and/or limitations by the authors in numbers four, five and six of their full set of limitations. Campbell and Viceira fail to consider that until now a large portion of the portfolio of such investors has been concentrated in restricted shares and options of the employing company, creating a non-discretionary skewedness of the portfolio and a need to consider the impact of such a phenomenon on the normative investment process.
The authors give the impression of being mildly annoyed by the whole field of behavioural finance. This is captured by their statement: "We do not believe that it provides a sound basis for a normative theory of asset allocation." It is rather as if oncologists trying to provide an empirical approach to cancer research were to decide to ignore what clinical cancer physicians were doing on a day-to-day basis.
The authors miss a fundamental point. Behavioural finance is of limited interest to the single investor or to the collectivity of investors.
Presumably these people know, or they can candidly ask themselves, how they feel about risks, rewards and the investment process. Rather, behavioural finance is of interest to the intermediaries and ultimate suppliers of investment services and products, who may choose to rely on this discipline to design and innovate their service and product ranges. Therefore, while indeed not very helpful in formulating a normative theory of asset allocation, behavioural finance is used to formulate empirical advice in asset allocation by the ultimate empiricists in this business, the financial planners.
There is no space here to go into the merits of the chapter-by-chapter systematisation of the authors' approach. This would have entailed quoting or attempting to paraphrase entire sections. More important, investors with particular needs will prefer to reflect in depth on each individual step.
A fair knowledge of portfolio management and investment literature would be required to make such an effort worthwhile. Finance academics will find a lot to interest them in this book; practitioners may be disappointed. This is not an empirical work in the sense that one can use it off the shelf, but it will provide material to improve on one's empirical reflections. So I still recommend it.
Rudi Bogni is a former investment and private banker and currently director or trustee of several institutions.
Strategic Asset Allocation Portfolio Choice for Long-Term Investors
Author - John Y. Campbell and Luis M. Viceira
ISBN - 0 19 829694 0
Publisher - Oxford University Press
Price - £22.50
Pages - 2