Dynamic Asset Allocation Modern Portfolio Theory Updated for the Smart Investor

Chapter 9. Equilibrium, Economics, and Estimates

Finance theory is complicated, but the first question for asset allocation is simple: should you own the market portfolio?

Yes, if you're comfortable with the long-term risk appetite of the average investor. If not, you can adjust the market portfolio to satisfy your risk profile and investment objective, which is what most investors will do and probably should do, although generic solutions here are elusive.

As the previous chapter explains, maintaining a custom asset allocation requires analyzing your general tolerance for risk, considering your investment horizon and identifying the betas that are important to you. This is what the new finance tells us to do, but beware: once you opt for something other than the market portfolio, you'll have to work harder. Unlike owning a passive allocation to the major asset classes, a customized strategy doesn't manage itself. Keep in mind, too, that there's no guarantee that the additional effort of designing and managing a personalized strategy will pay off relative to owning the market portfolio. The critical variables: your ability to analyze markets and make timely adjustments to asset allocation. Quite often these variables equate with adopting a contrarian outlook of some degree, which means that dynamically managing asset allocation will be challenging.

That's a price worth paying if the results are satisfying. But pursuing a different set of risk and return goals from what the market offers ...