Arguing with Mark Cuban on Asset Allocation

After reading Mark Cuban’s January post on his well-read “blog maverick” painting asset allocation as Wall Street hucksterism, I wondered if others had responded to his arguments. I found several interesting pieces, one that took Cuban’s tirade as a jumping off point for a discussion of the importance of understanding and believing in your allocation on My Money Blog and another on Darwin’s Money that made its point of view clear in its title: “Mark Cuban is Dead Wrong.”

Wall Street Hucksters

Before we get to the counterarguments, let’s first give Cuban his due. Cuban is a successful business man himself, having built a technology business and then sold it to Yahoo! in 1999 at the height of the dot com boom for over $5 billion in stock. Forbes reports his net worth at $2.4 billion, and he’s co-owner of the Dallas Mavericks and likes to dance (photo from Dancing With the Stars courtesy of ABC/Carol Kaelson). In his post, “Wall Street’s new Lie to Main Street: Asset Allocation,” Cuban argues that asset allocation has become the marketing slogan du jour on Wall Street now that the last “lie”, buy and hold, has failed to pan out very well. Instead of advising people to follow Peter Lynch or Warren Buffett’s advice to “buy what you know” (which in Buffett’s case is a lot of different stuff), Cuban rails:

Today, your investment advisors want you invest in things you have absolutely no fricking clue about and have pretty much absolutely no fricking ability to learn about.
They want you to diversify into Emerging Markets, Commodities, International Bonds, Munis, Real Estate Investment Trusts, ….and.. well, a lot of different “stuff”.

“It comes down to this,” he writes (in bold). “Do you want to invest in something you know, or in something Wall Street wants you to believe ?”

It’s not hard for me to believe that Wall Street might be looking for a hook and that it might not have the average investors’ interests at heart. Indeed, legally your broker is supposed to give his first allegiance to his employer, not you.

But in this case, I tend to think Wall Street may be delivering the right message, (though you may not want to buy how they’d like to sell it to you.)

Why Investing in What You Know Can Be a Bad Idea

Darwin’s Money argues in a response (Mark Cuban is Dead Wrong – Diversification Matters) that Cuban’s idea of owning what you know is flawed from the start. We all know our own company best, but because our paycheck, stock options and maybe, if we’re lucky, pension plan are all tied to that firm, owning more of it would be a huge mistake. How much doubling down does any person really want to make on that one bet? Darwin also argues that its not that hard to learn about your holdings (take a peak at the top ten holdings in a fund for starters) and that Cuban’s final point — that we should not “get greedy” and realize that capital preservation is more important than investing growth — is a recipe for disaster at a time of minute passbook savings rates and looming inflation.

A bit more than a week after Cuban’s piece,  YCharts ran a piece about the struggle to figure out how to pick winning growth stocks called “Want to Buy the Next Google or Apple? Lets See if You Can.”  Most investors predict future performance based on past results, the authors argue. In other words, what they can know about the company, its track record. But that’s not a good indicator. For every Google or Apple, that has extended its growth year after year in the 2000′s there is a Yahoo! or a Dell that couldn’t keep the good times rolling. The longer a growth streak persists, the less likely it is to continue, they found.

The Case for Asset Allocation

It’s interesting to note that Asset Allocation fans actually argue that Wall Street is not a friend to this strategy. Paul Merriman, author of “Live it Up Without Outliving Your Money”, wrote in a 2010 update of his research:

Your choice of asset classes has far more impact on your results than any other investment decision you will make. I know this flies in the face of a lot of conventional wisdom and almost all the marketing hype on Wall Street, so I want to repeat it. Your choice of the right assets is far more important than exactly when you buy or sell those assets. And it’s much more important than finding the very “best” stocks, bonds or mutual funds. A 1986 study, largely confirmed by a follow-up study five years later and often cited by investment managers, tracked the investments of 91 large pension funds from 1974 to 1983. The researchers concluded that more than 93 percent of the variation in returns could be attributed to the kinds of assets in the portfolio.

According to that piece, a hypothetical $100,000 investment made in January 1970, in 40% in government bonds, 60% in the S&P 500 would have grown to $3.8 million by 2009. If instead, the 60% in equities had been split among 11 different types of stocks, adding REITs, Microcaps, Emerging Markets and other classes to a smaller stake in the S&P 500, that total would have more than doubled to $9.3 million, without increasing the riskiness of the portfolios. Both have the same annualized standard deviation of 12% over the 40-year period.

Over different time periods performance will vary. In research done for Live It Up, published in 2005, Merriman looked at the 35 years between January 1970 and December 2004. During that stretch, he  found that more asset classes increased return, and also reduced volatility.

In the graphic below, financial advisor Steve Thorpe, plots the risk and reward numbers Merriman found in that original 2005 research starting with a “typical” portfolio as number one (60% S&P 500 Index, 40% Lehman Govt. Corporate Index (avg. maturity 10-13 years) and ending with No. 5 (6% Int. Large Cap, 6% Int. Large Cap Value, 6% Int. Small Cap Value, 6% Emerging Markets, 7.5% U.S. Small-Value, 7.5% U.S. Large-Value, 7.5% U.S. Micro-cap, 40% Short-term Bonds).

Along the way, Merriman has added a new asset type at each point . First switching out longer term bonds for shorter term, then putting a portion of the 60% in stocks into small stocks, then giving another slice to value stocks, and eventually splitting the equity holdings between large cap, international, small stocks and value stocks by point 5.

Which argument do you find convincing? Would you rather concentrate your bet on the things you know, or spread your bets and accept that you won’t know everything about a widely diversified asset allocation?

(Hat tip to Carl Richards’ New York Times Bucks Blog on the YCharts piece.)

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