Ruminating on Asset Allocation

Summary

• Asset allocation is a relatively modern concept that has evolved from the traditional 60/40 equity-bond split to include numerous choices regarding public vs. private assets, domestic vs. international exposure, and high vs. low quality investments.
• Computer models used for asset allocation often rely on historical data for expected return, risk, and correlation, which may have questionable relevance to future outcomes.
• The fundamental distinction between all investments is that they fall into one of two categories: ownership (equity) or debt (lending).
• Ownership assets involve putting money at risk with no promise of return, granting the owner a share of residual profits or cash flow after all obligations are met.
• Debt investments involve a contractual relationship where lenders receive a fixed outcome consisting of periodic interest and principal repayment, assuming the borrower honors the agreement.
• The primary decision in portfolio management is selecting a targeted risk posture that balances the mutually exclusive goals of preserving capital and maximizing growth.
• Ownership assets typically offer higher expected returns and greater upside potential but carry greater downside risk and volatility.
• Debt assets generally provide lower expected returns within a much tighter range, offering less upside but also relatively little downside.
• The appropriate mix of ownership and debt depends on the investor's specific circumstances, needs, and attitude toward bearing risk.
• Investors can maintain a fixed risk posture or adjust their allocation between offense and defense based on market movements and the relative attractiveness of offerings.
• Traditional linear representations of risk and return are inadequate because they fail to show that increased risk leads to a wider range of possible outcomes and worse potential bad outcomes.
• In an efficient market, there is no free lunch, meaning the ratio of return to risk is similar across all positions on the risk continuum.
• Moving further out on the risk continuum can be achieved by investing in riskier assets or by applying leverage to existing assets.