The inability of quantitative measures of risk and volatility to prepare institutional investors for the financial crisis has sparked a renewed interest in the art of asset allocation, writes DANIEL GRIOLI of FuturePlus.

In his book Capital Ideas, Peter Bernstein relates the story of how financial theories such as meanvariance optimisation, the capital asset pricing model and the efficient market hypothesis moved from the world of academia and into mainstream funds management. While many of these innovations were known in academic circles since Harry Markowitz’s seminal article on portfolio selection in June 1952, it wasn’t until the stock market crash of the mid 1970s that the funds management industry started to pay attention. Faced with the worst stock market crash since the Great Depression, funds managers and institutional investors responded by looking for better ways of managing money and – importantly – of controlling risk.

At this point they began to use quantitative measures of risk and diversification such as volatility and correlation. Aided by ever-increasing computing power, investment and risk management progressively became less of an art based on experience and more of a quantitative science. Risk could be easily quantified: it therefore appeared to be controllable. Once again, it has taken a financial crisis to create pressure for change throughout the world of investment. TRealising that risk isn’t just a number, investors have been asking themselves whether they could have done more to protect their portfolios. A result of all this soul searching is a renewed interest in asset allocation. To many people the idea of shifting a portfolio’s asset allocation in response to or in anticipation of market conditions makes intuitive sense. In his book, The Most Important Thing, Howard Marks describes the simple logic behind asset allocation: “There are few fields in which decisions as to strategies and tactics aren’t influenced by what we see in the environment.

Our pressure on the gas pedal varies depending on whether the road is empty or crowded. The golfer’s choice of club depends on the wind. Our decision regarding outerwear certainly varies with the weather. Shouldn’t our investment actions be equally affected by the investment climate?” With more and more investors recognising the need for asset allocation, the logical question is: how do you do it? why but not when As previously noted, classic portfolio theory reduces risk to a single number: volatility for absolute returns and tracking error for relative returns. As the last few years have shown, this methodology can be deceptive. Arguably a more appropriate measure of investment risk is loss of invested capital and the biggest contributor to a loss of capital is paying too much for an investment. Paying too much effectively locks in an insufficient reward or risk premium as compensation for investment risk. In contrast, investing at a discount to fair value or looking for a margin of safety helps to ensure that you are taking investment risks that are more likely to be rewarded. For this reason, valuation is central to most asset allocation strategies.

Join the discussion