A Modern, Behavior-Aware Approach to Asset Allocation and Portfolio Construction
Diversification has been the cornerstone of investing for thousands of years as evidenced by timeless proverbs like “don’t put all your eggs in one basket.” The magic behind diversification – and one of the reasons it is considered the only “free lunch” available in investing – is that a portfolio of assets will always have a risk level less-than-or-equal-to the riskiest asset within the portfolio.
Yet it was not until Dr. Harry Markowitz published his seminal article “Portfolio Selection” in 1952 that investors had a mathematical formulation for the concept. His work, which ultimately coalesced into Modern Portfolio Theory (MPT), not only provided practitioners a means to measure risk and diversification, but it also allowed them to quantify the marginal benefit of adding new exposures to a portfolio and to derive optimal investment portfolios. For his work, Dr. Markowitz was awarded a Nobel prize in 1990.
The theory, however, has its shortcomings. The assumptions that asset class returns are normally distributed and that expected returns, volatilities, and correlations are both known to investors and are static over time fail to hold up to empirical evidence. Unfortunately, these assumptions appear to fail spectacularly during market crises: the very times that investors rely on diversification the most.
In light of these shortcomings, some have begun to question the merits of asset class diversification and MPT. With the benefit of perfect hindsight, the diversified portfolio will never be return optimal. It will always contain asset classes that disappoint. To judge the outcome of diversification after the fog of uncertainty has lifted, however, misses the point. Diversification is valuable precisely because investors don’t know what the future holds. We can be vaguely right instead of precisely wrong.A-Modern-Behavior-THEME RESEARCH