Pragmatic Capitalism

Practical Views on Money, Finance & Life

The “Allocation Matters Most Hypothesis”

My latest post on “passive” indexing made some people upset.  I have argued, in essence, that there is no such thing as “passive” investing and that most people who use the term don’t really understand that what they’re doing is actually quite active and forecast based.  These are not “strawman” comments or misunderstandings as some people (see here and here) have claimed.  They are incontrovertible facts grounded in macro realities.  Let me explain.

Fact #1 – At the macro level there is only one portfolio of all outstanding financial assets.  If you were a truly “passive” investor you would simply buy the total market of financial assets as opposed to trying to pick your own superior portfolio based on assets inside of the aggregate.  Of course, that portfolio can’t be purchased because that portfolio product doesn’t exist.

Fact #2 – We all allocate assets differently from the aggregate financial portfolio thereby rendering us all “asset pickers”.  This asset picking requires some level of forecasting or underlying prediction based on how your risk tolerance relates to how you expect a set of financial assets to help you meet your financial goals.  You can claim that your approach doesn’t rely on forecasting, but that’s like claiming that your ability to successfully sail from San Francisco to Hawaii does not rely on a weather forecast – it’s just not true.

Fact #3 – This portfolio and your risk tolerance to certain assets will evolve over time which will require you to maintain and alter the above portfolio in some manner.   Therefore, it will require some level of upkeep and maintenance even if this is rather minimal over time.

The above facts should not be controversial.  Anyone who constructs a portfolio has to accept the reality that they are an asset picker of some sort.  They should also acknowledge that their perception of risk and the underlying risks of assets changes over time.   Therefore, we are all asset pickers who are required to maintain an evolving portfolio over time.  Again, these facts should not be remotely controversial.

When someone tells you to invest in a “passive” portfolio they are basically telling you to pick broad indexes of assets and maintain a tax and fee efficient structure.  I don’t disagree with this concept AT ALL.  But what seems to have happened over time is that many people who advocate “passive” indexing seem to have forgotten the most important part of portfolio construction – the actual process and necessary forecasting of the assets you pick to allocate.

We know that John Bogle was right when he constructed his “Cost Matters Hypothesis”.  It should be another incontrovertible fact that the less active investor who buys the aggregate market will outperform the more active investor who buys the aggregate market.  Costs matter.   But we should also remember that the most important driver of portfolio performance is not the result of cost and tax structure, but allocation.  Therefore, I think one must adopt the most important hypothesis of all when constructing a portfolio:


And make no mistake – when you allocate assets inside of the global aggregate financial asset portfolio, you are indeed making an implicit forecast and “picking assets”.  The investor who doesn’t embrace this reality is simply not understanding what they are doing.  So yes, costs and frictions matter.  John Bogle was right.  But the passive investing ideology seems to have gone a bit overboard in emphasizing these points.  And in this pursuit to differentiate themselves from “stock pickers” and “active” investors they have lost sight of the reality that what they are involved in is a process of asset picking that will leave some asset pickers inevitably outperforming others who engage in that process utilizing a superior understanding of what it is that they are doing.


Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering low fee asset management, private advisory, institutional consulting and educational services.Cullen is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
Cullen Roche

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