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Posted by on Jun 29, 2017 in ETF Strategist, Featured

Meir Statman Says Time Diversification Is Hokum

Meir Statman Says Time Diversification Is Hokum

By Roger Nusbaum, AdvisorShares ETF Strategist

He didn’t use the word hokum but he attempted to debunk the concept in an article posted at Market Watch.

The concept of time diversification is easy to understand; with a long time horizon you have time to recover from some sort of calamity that takes stocks down. This all hinders on the belief that equities will continue to go higher (bear markets and crashes notwithstanding) as they always have.

Statman’s opening argument begins “consider an investor who invests $1,000 in a portfolio with a 50–50 chance to gain 20% or lose 10% each year.” To me the argument is lost right here in the open as there are an almost infinite number of different outcomes not two outcomes. Statman lays out the math which is obviously correct but it is an isolated, academic framing of the issue to the point of being overly academic.

I would lump this in with the idea of alpha being finite (there are an infinite number of circumstances where someone could generate alpha, even if accidentally) or for every seller there is a buyer (when you sell you could be selling to a market maker or other liquidity provider whose job it is to facilitate trades, your sale could be paired off with a short closing out so your both exiting the name, the “buyer” could be implementing some sort of larger options strategy).

Part of Statman’s argument is behavioral (he knows a lot about behavioral finance) and yes some investors have and will continue to do themselves in by being too greedy or too fearful but that is not a failing of time diversification.

We all remember after the tech wreck that there were plenty of people who said we’d never make a new high in the NASDAQ again. Think about all the fear that the world was ending in 2008 (I’ve told the anecdote about a financial advisor needing me to tell him the world wasn’t going to end a bunch of times). These scary market events happen and then a new high gets made eventually. Even the Nikkei will at some point make a high (it traded close to 40,000 in 1989 and is around 20,000 now). The variable is when. Anyone not believing in that or worried it won’t happen next time either needs to lighten up on equities or employ some sort of tactical strategy that spares the full brunt of the next decline.

In these sorts of posts, I always mention something about having a suitable asset allocation mix (50/50, 60/40, whatever is suitable). One idea that came into greater awareness in the immediate aftermath of the financial crisis was to greatly reduce equity exposure a year or so before a planned retirement date. The idea is that with a year to go an investor’s portfolio is likely large enough to sustain the desired retirement lifestyle, or is very close to that level, and should the circumstance occur that in that final year before retirement there is a bear market that takes away 18% of the portfolio (a 30% market decline on a 60/40 portfolio) could easily be a difference maker in someone’s retirement plan. To the point of time diversification, the market will come back after some period of time but withdrawals taken at or near the bottom (assuming that 18% decline, or any other number you think relevant) obviously means it will take longer for the portfolio to get back to the level it was one year before retirement.

I don’t think of this as attempting to time the market but wouldn’t argue with anyone who says otherwise, I think of it as actively managing asset allocation. One risk though is opportunity cost which is why above it says greatly reduce, not eliminate. And before doing something like this an investor should have a strategy to get back in be it time or based on some percentage decline or both. Growth will still be needed for most investors, if anything this would be more of a brief timeout.

The AlphaBaskets blog provides frequent market insight and commentary by AdvisorShares Investments, LLC, created by AdvisorShares and other leading active managers.  AdvisorShares Investments is an SEC-registered investment adviser and the investment adviser to the AdvisorShares actively managed ETFs. The views expressed on AlphaBaskets should not be taken as investment advice or a recommendation for any of the actively managed ETFs advised by AdvisorShares.