Dynamic Asset Allocation Modern Portfolio Theory Updated for the Smart Investor

Chapter 8. Customizing Asset Allocation

The asset allocation choices are virtually limitless, but most of them are wrong. Finding the one that's right is the goal, of course, but the task is tougher than it sounds because the optimal asset allocation varies depending on the investor.

Everyone should design a portfolio that's tailored for their circumstances, which means there's just one asset allocation that matches each investor's expectations, objectives, and risk profile. In practice, identifying the absolute perfect mix of assets may be impossible. So it goes when trying to anticipate the morrow with imperfect information today. But at least we know where to begin: the market portfolio.

As we've discussed, the global market portfolio—holding everything in its market-value weights—is the default asset allocation. The standard finance theory tells us that this will be the optimal portfolio for the average investor for the infinite future. By definition, this investor is a composite of everyone, so it's unlikely to complement a real investor's risk/return profile. That suggests that everyone should adjust the unmanaged market portfolio to suit their specific situation. To the extent you're something other than average, your financial personality should be reflected in your asset allocation.

The standard solution is the separation theorem of Tobin (1958), which tells us to adjust the cash allocation relative to the market portfolio. Investors with a greater appetite for risk would ...