We just ran across a fascinating little discussion of strategic asset allocation in Morningstar Advisor. Insofar as most asset classes suffered ugly losses in 2008 (in our Allocation Portfolios, the only exceptions were Treasuries and cash), one might wonder what lessons we should learn from the crash. We recommend the entire interview, but here's a highlight from David Drucker's conversation with Roger Gibson (emphasis added in underlined text):
Drucker: Was the 2008 market decline within the realm of possibility given the historical volatility of returns?
Gibson: Using Ibbotson data for the U.S. market from 1926 forward, the simple average return of S&P has been roughly 12%. If the S&P returns are normally distributed--which they're not perfectly--then you'd expect 95% of annual returns to fall within two standard deviations. One standard deviation is 20%, so two standard deviations give us a return range of negative 28% to plus 52%. Five percent of all observations would fall outside that range, so we know 2.5% of all observations will fall outside the range on the low side, and also on the high side. So looking back to 1926, we find the market's return outside two standard deviations three times: 1931, 1937 and 2008. Of course, you would also expect to see several years when returns fell in the 2.5% portion of the distribution on the high side, and we did see this in 1933 and 1954. So my point is that if you look at what happened in 2008 in the context of the good data we have on the U.S. market, and if you assume distributions are relatively normal, we actually have had experiences in the tail ends of the distribution that coincide with what we'd expect.
Drucker: So 2008 wasn't as improbable as most of us think?
Gibson: Not really. It was a crazy year, but we know those marbles are somewhere in the urn waiting to be picked. But I'd put all of this into an even longer historical context.
Drucker: How do we do that?
Gibson: We don't need to necessarily do anything differently. What will change [going forward] isn't volatility, but capital market assumptions. In other words, relative to whatever capital market assumptions advisors have been working with, 2008 will raise expected returns--in absolute terms--going forward, the spread between equities relative to fixed income will widen, and all kinds of risk premiums will widen too as a result of last year's experience. So if we look back through time, we were in a lower absolute return and lower risk premium world and, going forward, we'll be in a slightly higher absolute return world and higher relative risk premium world. During times of excessive optimism, people overshoot markets on the high side, and during times of extreme fear and panic, markets overshoot on the downside. In 2008, people panicked and dumped securities, which sets the stage for higher-than-normal rewards for people holding on.
Now go read the rest. It's all good stuff.