A slight exaggeration in the making?

Earlier this week the U.S. government published its forecast for the budget deficit in coming years. In summary, the deficit is expected to narrow as a result of planned cuts on expenses but also, and this is where there seems to be a bit of an exaggeration, a substantial increase in receipts which, believe it or not, is hoped will come from expectations of a recovery combined with a planned increase in taxes and other forms of income. The goal is that the deficit drops from the current 10% of GDP to 3% by 2017.

So how realistic are these projections? I have a hunch that a large amount of the reduction actually bets on a strong recovery and that is where the problem lies. In the context of the current environment, it is difficult to see how the recovery can take on a sustainable path. Short term, maybe so, given the extension in tax breaks and the impact of the second round in quantitative easing, but longer term, probably not. In other words if the deficit, instead, remains stagnant or, worst case scenario, continues to widen, we can expect further pressure not only with regards to borrowing costs but also on the greenback. A weaker currency should undoubtedly help boost the economy by boosting exports to emerging countries, but if you factor in the brewing inflation troubles facing those same countries, the outlook suddenly looks bleak when compared to the "goldilocks" scenario of the government.

Reconciling Asset Allocation and Market Exposure...

According to a paper published by Gary Brinson in the 80's, the asset allocation decision was thought to be the single most significant contributor to performance, explaining roughly 80% of overall performance in a portfolio. His work was quickly noticed and widely adopted by the industry, remaining unchallenged for almost 3 decades. In early 2010, Ibbotson et al. published a research paper in the Financial Analyst Journal (FAJ) in which they disproved Brinson's original assertion. According to them, Brinson had mistaken asset allocation for market exposure. In other words, it was market exposure rather than asset allocation that contributed most (60%) to performance although, combined with asset allocation, the contribution hovered again around 80%.

The conclusion from this study would be that most of the effort in portfolio construction and investment policy should be put into determining market exposure and asset allocation rather than asset allocation by itself.

Controlling market exposure would require a form of market timing but, as any honest investment professional will tell you, trying to time the markets over the long run is a futile and sometimes very costly exercise, mainly because of the inherent randomness of markets.

On the other hand, studies have shown that if it were possible to mitigate the degree of drawdowns over the long run, doing so would substantially improve the end performance result.

Since controlling market exposure may require large changes in asset classes, isn't combining asset allocation and market timing a contradiction in terms? Dont you actually substantially change your asset allocation if you fully apply market timing? The answer is yes, but you have to think of the asset allocation element as a sort of structural backbone or foundation of the portfolio. The asset allocation decision is a pure function of the risk profile of the investor. It is the default portfolio exposure when the market conditions are "normal" or when asset classes behave as expected. Market exposure is more of a tactical overlay, its main purpose, at least in this context, is to mitigate the impact of drawdowns. In other words there is no contradiction to speak about when the roles of asset allocation and market exposure are clearly defined.

Coming back to timing markets, it is a futile exercise if human judgement is involved in the decision process. There are certainly ways around this, and if done properly, it can lead to a much better control of performance.

Negative Tail risks in 2011 and beyond...

The world will probably not come to an end in 2011 or even in our lifetime for that matter but there is something else that is likely to rock the rest of our lives: "black swan" or "fat tail" events.
They have always existed but, unfortunately, human memory suffers from a bout of short termism, we tend to forget longer term experiences, especially if they are unpleasant. I guess it is an inherited trait of our ancestors which explains why the human spirit tends to be on average optimistic. Because of our short term memory bias, however, we dont realize that "fat tail" events in fact occur more frequently than we think they do. Also I would add that a "black swan" event can also be a pleasant one such as when a major market rally occurs but we like to concentrate on the negative end because that is what needs to be controlled.
For this year, we see several risks that have negative "black swan" potential. The table above summarizes the more important ones.