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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.


  1. John Daschbach

    A corollary of Fact 1 is that the global total financial asset portfolio can’t have growth greater than the global growth rate over long time periods. Financial assets are just claims against real assets (real productivity and discounted fixed assets) and so the real value of financial assets includes the relative allocation of these factors (especially real productivity) between parties (specifically the producer of the real asset and the non-producing holder of the financial asset).

    Thus at some level, the allocation question comes down to which financial assets have a higher relative return to the holder of the financial asset. For instance in the US it appears that over the past few decades that the relative allocation of real productivity has favored the holders of specific financial assets.

    It seems probable that the variance in the relative shares allocated to the producers of real productivity and the holders of financial assets is greater than the variance in world productivity.

  2. Cullen Roche

    Beware the person who claims they DON’T have an agenda!

    Seriously though, I dont know what’s even controversial about this. Stock pickers pick assets inside of an aggregate (like the S&P 500). Asset allocators pick assets inside the global aggregate. The performance of both strategies will rely, to a large degree, on the ability of the asset picker to forecast what those assets will do in the future.

    Now, “passive” investors want you to think that they aren’t making forecasts because they use aggregates. But that’s not really true. They’re using indexes INSIDE the global aggregate. So, a 60/40 stock/bond allocation is an expliciti prediction that that portfolio will suit your needs better than the global financial asset portfolio.

    We all agree that costs matter. But passive investors seem to think they’re not “asset pickers”. And in constructing this strawman differentiation between themselves and “active” investors they’ve lost sight of what it is that they’re engaged in….

  3. Frederick

    No need to convince me.

    I thought it was funny – if you look at that BogleHead forum it’s mostly posts pontificating on the potential future performance of certain asset allocations. You could swap “50/50 XYZ Funds or 60/40 ABC Funds” out with “General Motors or Ford stock” and they’d both be doing the same thing – picking assets. But the passive indexers seem to have convinced themselves that they’re not actually asset pickers. LOL.

  4. Cullen Roche

    Confirmation bias at work. If you pick assets, but convince yourself that it’s not really “asset picking” and doesn’t include forecasting then you effectively convince yourself that what you’re doing is necessarily smarter than all other alternatives because there is no other alternative.

    And yes, those forums read just like a stock picking forum. Except these people are all trying to PREDICT the most effective asset allocation. Oh well, if they want to think they’re not picking assets actively then who cares?

  5. ciwood

    I do not pick an allocation. After 30 years of doing it poorly, I chose to punt and let Vanguard wellington have all my money and allocate for me. They did well enough in 2008 to keep me from panic selling as I have always done in the past. I will ride this horse home. I am 65.

  6. Cullen Roche

    Great example of what the myth of “passive indexing” has convinced people they are doing….Vangaurd Wellington is a 60/40 stock/bond fund with home biased asset picking. You have most certainly picked an asset allocation. And that asset allocation will depend on how the underlying assets perform in the future. You’re picking an asset allocation and relying on an implicit forecast.

    This is what’s dangerous about the “passive indexing” myth. People are just blindly constructing portfolios without really understanding what they’re doing…

  7. John Daschbach

    For a large fraction of people the largest asset allocation decision they make is regarding housing which is always an active choice (buy, rent, where, how big, …). One could argue that some part of the recent problems are the result of an increase in active asset allocation to housing pre-2009. One can make a case that the “Balance Sheet Recesion” concept is in part just a change in asset allocation.

  8. Frederick

    You’re picking a fund which has picked an asset allocation. This doesn’t mean you aren’t picking assets, picking an allocation or making a forecast. It just means you don’t understand what you’re doing.

  9. billyjoerob

    Why limit the pool to financial assets? Choosing financial assets is another form of allocation. You have chosen financial assets in place of real estate or gold or art or investing directly in businesses.

  10. Cullen Roche

    You could do that. As John noted below housing makes up the majority of total assets so it could make sense to include those as well. I just excluded them in the thinking here because the inclusion of non-financial assets makes the asset pool almost incalculable. It’s just easier to use financial assets because we can quantify it more easily. But yes, if we could include non-financial assets as well. It just becomes a more complex picture then.

  11. Cullen Roche

    So…I’ve gotten a number of emails and Tweets from some of the BogleHead advocates. They’re extremely combative and protective of this “passive” view. Almost militant in their argumentative nature. It’s really weird.

    The idea that they’re making forecasts and “picking assets” seems to make them very uncomfortable. I don’t know why it matters. So what. You pick assets. So what. You rely on an implicit forecast. I don’t think anything I am saying is really controversial once you understand it, but it seems to really bother a lot of people.

    My guess is that the idea that they’re not actually that different from stock pickers is kind of ruining parts of the narrative. But that’s precisely the problem here. In their overzealous attempt to differentiate themselves they demonized certain perspectives for the wrong reasons. And it’s resulted in a lot of confusion about what people are really doing when they allocate assets. Which, in my opinion, is a big disservice and a point worth clarifying.

    We should embrace the reality that we’re all asset pickers. We should embrace the reality that we’re all dependent on a forecast of some type. We should embrace the low fee and diversified approach. But don’t go into this thinking you’re not picking assets or relying on a forecast of some type. That’s a very dangerous way to allocate assets….

  12. Shervin

    I wouldn’t waste time responding to them unless they are actually seem to be open to changing their minds. An emotion response indicates a lack of objectivity, which means they are immune to rational arguments.

    More importantly, are there any worthy additions to the Pragcap Ad Hominem Hall of Fame?

  13. John Richards

    Isn’t it true that nobody knows what they are doing? Sure, a few people have a bit more of a clue, but methodologies are based upon assumptions – for the most part in this business, those are demonstrably incorrect assumptions, in other cases simply un-proveable. I admit, I’ve winged it for 20 years relying on various rules of thumb supposed to represent conventional wisdom. All in all, I got my 9-10% returns on average over that time, but I can’t claim there was much skill demonstrated in achieving those results, and I could easily be +/- 5 pts over that time.

  14. tealeaves

    Unless someone has a allocation methodology and can show they can allocate capital in a manner that is superior to an arbritary passive portfolio then this is a silly conversation.

    Speaking for myself, as an average dumb investor, a simple 60/40 (I use a modified permanent portfolio with different weightings etc) and rebalancing with fewer portfolio changes is a “better” approach. If you are a money manager or financial advisor then sure. And if someone will tell me how to interpret macro machinations to influence my allocations then great I’m all ears. But telling me I’m wrong doesn’t help me.

    Personally I have tried to modify my allocaiton so I could avoid a replay of the 2009 drawdown but over the long run I have done worse then 60/40. Of course, that doesn’t mean asset allocation doesn’t work. But maybe it means for the me – the “average” dumb investor that over guessing and making portfolio changes based on my interpretation of macro doesn’t add enough value. And I’m still trying to improve my macro understanding. But I’m more more convinced that for some of us simpler is better.

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