Investors want to grow wealth and avoid large drawdowns along the way. But portfolios with higher expected returns also carry greater risk. Faced with this trade‐off, investors choose portfolios that optimally balance their goal to grow wealth with their aversion to risk. This approach to portfolio selection implicitly assumes that risk is stable through time, which is far from true.
In Chapter 13, we showed that accounting for stability in portfolio construction helps to stabilize portfolio risk by reducing a portfolio's dependence on asset classes with unstable risk profiles. But even stability‐adjusted portfolios experience large swings in standard deviations through time. As an alternative, we could engineer a portfolio to perform well in a given regime, with the hope that it holds its own when that regime does not come to pass. This strategy, like stability‐adjusted optimization, selects a set of fixed weights, but it is constructed to perform well in a particular regime that we fear the most or which we believe is most likely to occur. Unfortunately, this approach is also subject to large swings in portfolio risk. It is hard to stabilize the risk of a portfolio that has fixed weights.
It may be preferable to allow our portfolio's asset mix to change through time. If we successfully predict future investment conditions, we should be able to outperform a static asset mix with tactical tilts. Of course, if our predictions are wrong, tactical ...