Comments on Rick Bookstaber: Asset Allocation

On commodities: it is an asset class because a). i...

2009-10-02T19:36:51.460-04:00

On commodities: it is an asset class because a). it has real return tracking the inflation. b). it is not entirely correlated with other existing asst classes.

On the other hand, the 'new normal', as what Bill Gross and others termed it, absolutely requires a diversification not just over static assets.

The best piece of paper I ever read is the diversification over asset classes and strategies. I suggest everyone to take a look at here: http://seekingalpha.com/article/151754-diversify-asset-classes-and-investment-strategies

Perhaps it is a mistake to say asset allocation do...

2009-09-23T20:58:56.165-04:00

Perhaps it is a mistake to say asset allocation does not work in a crisis. I think it is safer to say it does not work as it is currently taught in a crisis. As it is currently taught, you place many asset classes in the portfolio at various weightings to get a certain target std. deviation which is used as the measurement of risk/volatility....

To get to a more truthful use of asset allocation one must look as a more basic definition; mixing non-correlated asset or low correlated assets in order to lower the risk. Now, isn't that the same thing you ask? Well, no. Asset allocators commonly use the long term numbers for asset classes...long term correlations, long term standard deviation...big, BIG mistake. First, we are in an ever changing world--and frankly, not every financial number reverts to a long term mean. Emerging countries become developed, developed empires crumble, trade across borders becomes freer and then cycles to constricted, stable currencies de-stablize... There are many a research paper at university level, professional level, whatever that observe the increasing correlation of a wide variety of asset classes. Logic would therefore cause one to conclude that the effectiveness of allocation models relying on old, aged numbers is going to yield unsatisfactory results. I showed to co-workers that the tenant of asset allocation held true in 2008 if properly applied. There were 2 asset classes non-correlated to equities (and by equities, I mean ALL equities domestic and intl), and those were US Treasuries and Cash. Everything else was near extreme correlation well before the fireworks of Sept-November of 2008. So if you took a S&P500 etf, a treasury etf, and cash and mixed them to an appropriate std. deviation (let's say half of the S&P500 for a risk adverse individual), you would have gotten more than acceptable results even in the peak of the crisis.

The fallacy of allocation modeling is the thought that the inputs are static and timeless. There is no such thing.

"Since this is so well known, why do we keep ...

2009-09-23T16:50:22.884-04:00

"Since this is so well known, why do we keep having financial meltdowns in which diversification/correlation was used as the major avoidance of risk?"

I'll take a stab, Michael. Because the mathematical models are easy, and it allows advisers to sell investments that promise more return than they can likely deliver.

True risk reduction almost always involves lowering the return objective, and since Americans have not been great savers, they try to achieve their goals through aiming for higher returns, and thus adding unintended risk.

http://venturepopulist.com/2009/06/hybrid-portfoli...

2009-09-23T15:15:45.116-04:00

http://venturepopulist.com/2009/06/hybrid-portfolio-theory/

There is an answer.

2009-09-23T14:24:26.019-04:00

This comment has been removed by a blog administrator.

Rick writes: "During a crisis, when diversifi...

2009-09-23T12:56:50.515-04:00

Rick writes: "During a crisis, when diversification really matters, correlations aren't near zero (as if they ever are). All that people care about is risk and liquidity. All assets that are highly risky drop, all assets that are less liquid drop. No one cares about the subtlety of earnings streams. It is like high energy physics. When the heat gets turned up high enough, matter is just matter, the distinctions between the elements is blurred away."

Since this is so well known, why do we keep having financial meltdowns in which diversification/correlation was used as the major avoidance of risk?

In the subprime market, people rediscovered this by finding out that all housing markets can move together - downward.

I don't get how this institutional knowledge keeps getting lost.

It's difficult to get the professional advisor...

2009-09-23T12:46:58.752-04:00

It's difficult to get the professional advisors to recognize that the world is different and that the magic of diversification and asset allocation are significantly diminished.

Today new tools are need to control risk. My favorite is the collar, but that's not the only choice.