“Dynamic” asset allocation is born How do you pitch an old-fashioned idea such as asset allocation to a new audience? The marketing of emerging markets as an investment idea gives us a clue. Antoine van Agtmael came up with the idea to rename less developed countries “emerging” markets. He did so after struggling to raise a fund to invest in what were then known as third-world countries. Van Agtmael recounts: “We had the goods. We had the data. We had the countries. We had the companies. What we did not have, however, was an elevator pitch that liberated these developing economies from the stigma of being labelled as ‘Third World’ basket cases, an image rife with negative associations of flimsy polyester, cheap toys, rampant corruption, Soviet style tractors, and flooded rice paddies… Racking my brain, I at last came up with a term that sounded more positive and invigorating: Emerging Markets. ‘Third World’ suggested stagnation. ‘Emerging Markets’ suggested progress, uplift and dynamism.” Just as third-world equities would never sell, pitching the idea of going back to investing like we did in the past – focusing on value rather than volatility – would be a tough sell. Humans are biased toward action; therefore a name such as “dynamic” asset allocation naturally sounds appealing. It also implies that the alternatives are static, perhaps even boring.

DAA vs blank paper Most dynamic asset allocation begins with a strategic asset allocation, which is calculated using the long-term equilibrium risk and return assumptions for each asset class. In practice, markets are rarely in a state of equilibrium – the risk and return characteristics of each asset can deviate significantly from long-term assumptions. Dynamic asset allocation is then implemented as an overlay to compensate for the difference between long-term equilibrium assumptions of risk and return, and current economic and market conditions. The danger of this approach is that it anchors the portfolio’s asset allocation to the strategic asset allocation. Anchoring is a cognitive bias, which describes the common tendency to rely too heavily or to “anchor” on one fact or piece of information when making a decision. Once the anchor is set, there is a bias toward adjusting or interpreting other information to reflect the “anchored” information. Through this cognitive bias, the first information learned about a subject can affect future decision-making and information analysis.

How does strategic asset allocation anchor dynamic asset allocation? For example, a portfolio has a strategic asset allocation of 60 per cent shares and 40 per cent cash. As the fund manager responsible for the portfolio, you are concerned that equities appear significantly overvalued and so you decide to take a dynamic asset allocation tilt of -5 per cent shares/+5 per cent cash. Your portfolio asset allocation is now 55 per cent shares and 45 per cent cash. Did you notice the problem? Instead of considering cash and shares individually, using valuation, technicals and sentiment to form an opinion of the possible return and risk for each asset, you have begun with an anchor – a 60 per cent shares and 40 per cent cash portfolio – and positioned the portfolio relative to the anchor. The anchor has the potential to prevent you from fully analysing any new information and investing accordingly. It creates a mindset that focuses on adjustment to current values – in this case, the strategic asset allocation – rather than the absolute value of each asset.