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Is History Relevant to Today’s Markets?

At Hennion & Walsh, we learned a lot from the global credit crisis of 2008 which we are applying to how we approach managing wealth in 2009 and beyond. A lot of these lessons were just reinforcements of what we knew already in terms of the importance of asset allocation and the need for re-balancing. However, what 2008 also reminded us of is the danger of solely relying upon historical data when building and managing your strategic asset allocations. While history can often help in trying to ascertain future behavior or activity, I would argue that it is the period of history used for this purpose that is the most important factor in terms of relevance. Using too much historical data or period irrelevant historical data could result in skewed outcomes when building asset allocation strategies. Following this approach would also tend to not be forward looking enough to account for current market conditions – �rear view mirror� asset allocation modeling if you will.

Since nobody has a crystal ball, the question then becomes how to find relevant periods of history to guide us towards forward looking asset allocation strategies. At Hennion & Walsh, we approached this question by coming up with five potential scenarios, based on our research, for 2009. The reason for our one year outlook is that we generally re-visit our asset allocation model weightings annually. If you review your particular allocations more or less frequently, I would suggest adjusting the timeframe of your particular outlooks accordingly. Regardless, the five potential scenarios we used in our recent re-balancing included the following:

  1. Continuation of Bear Market
  2. Trendless Volatility for the Entire Year
  3. Significant Long-Term Bull Market
  4. Volatile 1st Half of the Year following by 2nd Half Market Recovery -> Bull Market
  5. Return of Inflation

We then assigned probabilities to each scenario, based on our research and opinions, and found relevant periods of historical data for each scenario. This data was then utilized to build our new asset allocation models which then led to the necessary adjustments for each affected client portfolio.

While no approach is fool-proof, we believe that by using forward looking assumptions, based on relevant periods of historical data when building asset allocation models, is an investment strategy concept worthy of strong consideration. By so doing, irrelevant periods of historical data would not be able to have such a significant skew on the results and, perhaps more importantly, employing multiple scenarios helps to dampen the negative consequences associated with unexpected market downturns when a single scenario approach is used. Remember that the forecasts of even the most experienced market experts are often found to be incorrect.
We are not alone in this approach as several of the larger pension plans and endowments in the country also share this philosophy.