Asset allocation models are used by investment firms to decide where to make financial bets and how to diversify portfolios. For reasons which are not entirely clear, but probably are due to a combination of transaction costs and steering on the part of financial institutions, asset allocation models very strongly tend to be domestically focused. That is for US citizens, they tend to allocate assets to US stock, bond, real estate or other US instrument classifications. There is far less written about global asset allocation that compares assets across different countries and makes allocations this way. This requires incorporating a larger database for analysis.
Often times investors will begin by finding stocks or real estate they find attractive. This causes them to become investors. This decision is bounded by the investments that are closest to the investor. This bias for local investments is documented in research. For instance, a real estate purchase is driven by proximity to work, while a stock purchase is typically driven by the country the person resides in combined with the stocks they are familiar with.
Information Sources
The reasons for these decisions is straightforward, as discussed in other areas of this website, national financial information is biased towards US stocks and mutual funds, and the local level publications are biased towards local real estate investments. Much of this has to do with commissions. The financial industry recommends products to consumers (thought investment advisers, getting certain mutual funds offered through 401k programs etc….) that benefit the provider of the product over the interests of the consumer. Finance professionals would disagree with this…but then again, finance professionals are out of credibility at this point, so their protests can be dismissed as self serving.
For years the US has had an obsession which borders on the fetish with real estate and US equities.
This story changes somewhat depending upon the country the person resides in. For instance in Singapore, while the real estate focus is local, the equities focus is on US equities because US equities are still more than 1/2 of all equity value globally. That bias may change in the future, but the point illustrated is that with every news information service there is a selection of some assets over other assets.
Often Unconsidered Factors
What is left out of this analysis is whether the overall asset class, of which the particular investment is a part of, is relatively undervalued or overvalued. This is important because even if you own a “good stock”, or a “good piece of real estate” when an entire asset class is overvalued, you will have to “fight the tide” rather than “go with the tide.”Therefore, the concept of a Global Asset Allocation Model is that you first want to start out in either undervalued or moderately valued assets classes, then once you have decided on the asset class, then the individual investment opportunity is determined.
Previous Global Asset Allocation Models
The Black Litterman model is the best known asset allocation model.The Counter Econ Global Asset Allocation Model (CE-GAAM) is based upon a somewhat different approach. It looks at assets classes on their relative strengths, and attempts to keep the investor our of historically overvalued assets, and positioned in assets that are currently undervalued historically. While the Black Litterman model asks the question related to liquid investments, the CE-GAAM also applies the same rule to present real estate holdings.The Black Litterman GAAM assigns a return and risk value to different global assets. These include:
- US Bonds
- Global Bonds
- GSMI Global Securities
- World Equity
- US Large Cap Value
- US Small Cap Value
- US Large Cap Growth
- Emerging Equity
- Small Cap Growth
Black Litterman Model
The concept is that a portfolio can be diversified across these assets in a way that matches with the risk profile of a client. The Black Litterman model is now the standard global asset allocation model at investment banks. This is differentiated from normal asset allocation models of which there are many.
We will be developing this article more in the future. We have considered developing an asset allocation model, but are presently restricted on time. The main point of this article at this time is to point out the relatively narrow view of the asset allocation models available to the normal (i.e. not ultra-wealthy) investor.
