Bear markets are painful, but they’re also educational. It’s debatable if the crowd ever learns anything in the money game, but the lessons are there just the same.
One of the lessons from the recent and current correction is that portfolios that appeared diversified were in fact far more concentrated than casual observation implied. There are many ways to measure, analyze, design and manage portfolios so as to maximize diversification’s benefits across asset classes. For the moment, we’ll briefly consider one in particular—so-called risk budgeting or risk allocation. The March issue of The Beta Investment Report will go into more detail on risk allocation, but here’s a brief overview of why the subject is relevant for strategic-minded investors.
In essence, the core insight of risk allocation is that there’s more than one way to define multi-asset class diversification. The most popular, alas, may be the most vulnerable to erroneous signals. Vulnerable or not, looking at portfolio allocations based on the capital mix is widely used. For example, a $100,000 portfolio with 60% of the dollars in stocks and 40% in bonds reflects a 60/40 asset allocation in capital terms. But capital allocation is only one measure of asset allocation. What’s more, it’s often a misleading measure if taken at face value without the benefit of broader analytical context.