The common features of all of these strategies are idioscyncratic risk and leverage, he says. “Trying to create wealth – or in the case of (an) institution, alpha – by deciding whether to put more in private equity or equities through asset allocation is a waste of time,” he said. Instead, investors should divide the management of their assets into three distinct buckets with different dynamics. They are: the safety net, which holds riskless assets; the market portfolio, which holds risky assets; and the aspirational portfolio for wealth mobility, which contains idiosyncratic assets. “In the three-bucket framework, the first is a safety net which expects a zero return, such as asset-liability matching, (while) the diversified bucket is your normal, diversified portfolio, and then there is an aspirational bucket, which is (for) wealth generation,” Chhabra said. The paper says that modern portfolio theory eschews idiosyncratic risk, in favour of leveraging well-diversified market portfolios, to achieve outperformance. But in the real world, leveraging the entire market portfolio is a risky and “often fool-hardy strategy,” Chhabra says. This is because investors searching for excess returns often become aggressive during bull markets – and wear losses as the market turns.

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