Chapter 3. On Asset Allocation: The Riddle of Performance Attribution

Asset allocation is no more complicated than Chance's lessons about the garden. We invest with faith in the financial markets, dividing our portfolios among distinct asset classes that blossom and wither in different seasons of the economic cycle. Following the simple logic of diversification, we seek to maximize our participation in the market's seasons of plenty, while ensuring that we survive its seasons of want.

For nearly all investors, the principal asset classes of choice boil down to common stocks (for maximum total return), bonds (for reasonable income), and cash reserves (for stability of principal). Each differs in risk: stocks are the most volatile, bonds are less so, and the nominal value of cash reserves is inviolable.

From the Talmud to Modern Portfolio Theory

In the past 25 years, we have come to frame the simple logic of diversification in terms of a rigorous statistical model developed by finance academics: modern portfolio theory. Investors almost universally accept this theory, which is based on developing investment portfolios that seek returns that optimize the investor's willingness to assume risk. Risk, in turn, is defined in terms of short-term fluctuations in expected value.

In its most comprehensive form, modern portfolio theory dictates that portfolio composition should include all liquid asset classes—not only U.S. stocks, bonds, and cash reserves, but international investments, short ...

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