Post Modern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World

Chapter 8

Asset Allocation

The Simple Way and the Hard Way

For many, the central question of modern finance is where to invest in order to maximize return relative to risk. Over the past 60 years, advances in financial theory and the introduction of new financial products, as well as the growth of new financial markets, have added complexity to how best to answer that question. For most investors, modern finance remains focused on the original portfolio selection approach put forth by Harry Markowitz (modern portfolio theory [MPT]). At its core, MPT is an analytical approach through which knowledge of the expected returns and the return correlation among assets provides a means to find a set of assets, which, in turn, provides the highest expected return for a level of expected risk. At its inception, simple correlation-based asset diversification was the principal means of return and risk management. What it lacked, in part, was a simple mechanism to forecast assets' expected returns. As noted in Chapter 1, the capital asset pricing model (CAPM) attempts to link all assets into a single-factor approach in which all assets are priced relative to their common sensitivity to a single common market portfolio, but CAPM is completely useless as a forecasting tool because (a) we need a forecast of the expected return on the market and (b) the portion of the stock returns not explained by the return on the market is rather large. To be fair, CAPM was not meant to be a forecasting tool; ...