History is unimportant in assessing clients' future investments, says UMass professor Thomas Schneeweis. What is important? Sussing out risk.
Focusing on past performance often is the first and biggest mistake financial advisers make when it comes to asset allocation, according to Thomas Schneeweis, professor of finance at the University of Massachusetts at Amherst.
Speaking in Las Vegas to attendees at the Investment Management Consultants Association's annual conference, Mr. Schneeweis drove home the message that financial professionals and their clients should be focused on risk instead of returns.
“Much of the past, though interesting, may have very little relevance on what we do today,” he said. “We are really here to create our own new picture of asset allocation, and I want to emphasize the unimportance of history.”
Mr. Schneeweis, co-founder of the Chartered Alternative Investment Analyst Association, pointed out that citing the performance of popular benchmarks as justification for certain long-term investment strategies is misleading and potentially dangerous.
“The S&P 500 today is really the S&P 50 and 450 other stocks we don't care about,” he said. “And commodities like corn and sugar are now energy investments.”
In discussing the historical performance of broad hedge fund indexes, Mr. Schneeweis pointed out that over the past 40 years, the leaders in the alternatives space have shifted across multiple strategies including global macro, currency trading, credit-driven, distressed debt, and quantitative.
Thus, looking at the long-term performance of the broad hedge fund category is not a sound justification for an allocation to hedge funds in general, he said.
“We can't look to returns and risk of past portfolios or indexes and apply it today,” Mr. Schneeweis said. “Opportunities change, but the risks remain the same.”
In order to estimate returns while building an asset allocation strategy, advisers first need to study and measure the risks, Mr. Schneeweis said.
“If we don't know the risks there is certainly no grasp of the return,” he said. “The solution is to understand the assets and the limits of risk measurement.”
As an example of where past performance can skew an investment strategy, Mr. Schneeweis pointed out the way some advisers use the long-term performance of bonds when calculating the estimated performance of an overall portfolio.
“You can't use a historical return of 8% for bonds because that's what they returned in the past,” he said. “Bond returns are based on today's yields and that's it.”
Mr. Schneeweis explained that the real value that financial advisers offer is not in forecasting returns but in managing risk.
“In the retail market, return is the focus, but in the institutional market, risk is the focus,” he said. “Your value to your clients in major market moves is managing the risk, so know the risk and manage the risk.”
