Thursday, 10 May 2007

Book Review: Asset Allocation by Roger Gibson

The mere fact that this book is now in its 3rd edition indicates that to some degree it has stood the test of time. It is indeed a very good book, much of it brilliant, but it has some serious flaws and a 4th edition could/should correct those short-comings.

Gibson's primary target audience is financial planners and US investors. There is nevertheless a great deal of value for individual investors everywhere and as a do-it-yourself investor, I found much of personal benefit. Though not for the absolute beginner, this book is at an intermediate level and is understandable to anyone who has been dabbling in mutual funds and knows generally about bonds. He explains terms and builds knowledge carefully from a fairly low level, utilizing the results of finance research without delving into the heavy duty maths that characterize modern finance.

The subject matter of the book is not individual stocks and how to pick winners. It is instead about how to make money investing using a kind of tortoise strategy - moving ahead steadily but not spectacularly, in any given year always being behind the current winner but never worst, with the least chance of actually losing money and over the long term being ahead of every individual investment asset alternative. That approach is termed asset class investing in a portfolio built on observed diversification benefits of asset classes. Asset classes are groupings of investment securities that go up or down out of sync with one another, for example, the US stock market, international stock markets and real estate investments.

Gibson does a great job explaining how this works, with numerous graphs and tables using historical data. Chapter 8, titled the Rewards of Multiple-Asset-Class Investing is superb and worth the price of the book alone. Using a didactic method, he unveils the subject matter progressively to surprise the reader with the wonderful diversification benefit that I described in my previous post 3+1=5. This powerful result tells us to diversify using various asset classes such as international stock markets and real estate securities. It was very interesting and comforting for me to read the next chapter on portfolio optimization in which he shows how small changes in any of the inputs (estimates of future returns, volatility and correlation) among asset classes can have enormous effects on the computed optimal percentage allocation asset classes. This is comforting because a key decision is how much to put in Canadian equities vs US equities vs international vs fixed income/bonds. It doesn't matter enormously. Gibson's result is that there isn't a known correct answer - the most important benefits come from the different asset classes being represented, not the exact proportions, so one should spread out the investments relatively evenly (his answer is no less than 5% nor more than 20% in each).

This book does a very good job presenting the principles of asset class investing but does not get as detailed as Richard Ferri for example, whose book I previously reviewed, in identifying other useful asset classes for a portfolio, such as small cap stocks, value stocks and commodities. These asset classes do show up later in Figure 12-2, the Investment Portfolio Design Format but without any supporting explanation of why they are there. The book also does not get down to the actual securities that one can buy to build the portfolio, such as mutual funds and ETFs.

Some of the principles of asset class investing may surprise, e.g. tax minimization and income stream generation must be secondary to the proper asset allocation in a portfolio, which means among other things, do NOT design your portfolio with too much fixed income just to have interest income to live off in retirement. If you need money to spend, sell some of whatever asset class is currently above its allocation.

Where the book falls down in a significant way is the last quarter of the book from chapter 12 on, in which Gibson gives financial planners advice on how to deal with clients. In this section he seems to abandon substantiation and give arbitrary advice, or even worse, present as viable, options that are contradicted by material in the first part of the book. For example, on page 251 and elsewhere he seems to accept that "frame-of-reference" risk (the feeling by his client investors that they want to not be different than their peers), is puzzling to say to say the least. Isn't is desirable to do better and thus perhaps inevitably different, than one's peers? And isn't it the financial planner's professional duty to guide the investor to better and probably different approaches to investing? The advocacy of dollar cost averaging as an investment approach on page 265 is simply wrong, as Moshe Milevsky shows in his book Money Logic (maybe Gibson succumbed to frame-of-reference risk too as no less a luminary than Sir John Templeton, founder of the Templeton Funds, repeats the same mistake in the forward on page xii). The worst sin of all is Gibson's acceptance of an active management approach by trying to pick asset class winners and timing the market on pages 260-261. The rest of the book says that is not necessary or desirable but Gibson blesses it here because some financial advisors do it. He should be stomping all over the idea. Similarly, on page 272-273, Gibson discusses mutual fund fees and manager's compensation as justified - "Similarly, at the level of individual security selection, the money management specialist should be paid for work well done." I ask, what work, what security selection? Doesn't one just buy the index/market of the asset class? Let's see, for the Canadian stock market amongst low cost alternatives of funds or ETFs, there are maybe half a dozen and a good advisor should know them by heart, have one already determined by previous research (mine is XIU). How much is that worth - 1% fee on assets per annum? There's no on-going work. Perhaps a flat one-time fee?

There is one great quote cited in the book. Asset class investing, despite being superior, cannot ensure that one makes money investing. Paul Volcker, former US Federal Reserve Chairman: "You cannot hedge the world." (p.304) At times of world crises, all asset classes become one and move together. There is no escape. And if the crisis were something like nuclear Armageddon or global environmental collapse, it wouldn't matter anyways.

Despite the flaws, this is a book worth buying. It gives one the knowledge and the confidence to go ahead to select the actual investment securities for a diversified portfolio. My rating, 3.5 out of 5.

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