Portfolio diversification long has been viewed as a key strategy for managing investment risk. In theory, by combining assets based on their expected risk, return, and correlation patterns, investors should be able to build portfolios that best manage the trade-off between their long-term return objectives and their tolerance for asset price volatility.
Actual investment results, however, have frequently failed to match up with financial theory. In particular, investors have repeatedly discovered, to their dismay, that traditional diversification techniques may understate their potential exposure to loss in times of market stress.
An Expanded Approach
I believe that there are additional tools (such as tail-risk hedging, defensive momentum strategies, and dynamic risk-based strategies) that investors can use to manage portfolio risk, especially “tail” risks-the potential for disrupted markets to generate shorter-term performance patterns that are far outside the historical averages.
While these additional strategies cannot replace traditional asset allocation, they can, in my view, supplement it. This potentially can improve portfolio diversification and enhance the level of satisfaction that investors derive from a given portfolio and its performance over time.
In thinking about diversification using traditional asset allocation, it is helpful for investors to focus on the three sequential building blocks of the asset allocation process: return forecasting; risk forecasting; and, after that, portfolio construction.
To fulfill a complete asset allocation approach, each building block—and the ideas, processes, investment views, inputs, and models that go into them—must build on the others.