My Current View on Practical Asset Allocation

Recently, I read "A Fundamental Approach to Personal Investment" by David Swensen. Swensen strongly recommends that investors focus on asset allocation, rather than market timing and security selection, to generate returns. He introduces concepts from Modern Portfolio Theory (MPT) to support this approach.

Modern Portfolio Theory: A Brief Overview

Inputs:

• Expected return for each asset
• Standard deviation of each asset as a measure of risk
• Correlation matrix between assets

Output:

• The efficient frontier: a set of portfolios offering the maximum expected return for a given level of risk, or the minimum risk for a given level of expected return

Key Insights:

1. Mixing assets with uncorrelated returns reduces overall portfolio risk
2. Systematic risk cannot be diversified away, as it affects all assets

Limitations of Modern Portfolio Theory

Like all models, MPT faces the "garbage-in-garbage-out" problem:

1. Predicting expected returns: Historical data may not accurately represent future performance. For example, S&P 500 returns vary significantly depending on the selected time period.
2. Measuring risk: Standard deviation may not be the best measure of risk for all investors. Risk perception varies based on:
   • Investment horizon
   • Concerns about upside potential vs. downside loss
   • Assumptions about return distribution
   • Emphasis on tail risk
3. Correlation reliability: Past correlations may not reflect future relationships, as historical data doesn't explain the causal mechanisms behind asset movements.

The Value of Modern Portfolio Theory

Despite its limitations, MPT offers valuable insights for investors:

1. It decomposes portfolio returns into three components, providing direction for asset allocation:
   • Find less correlated assets to improve risk-adjusted returns
   • Consider investment horizon when determining the basic allocation between stocks and bonds
   • Recognize that all-stock or all-bond portfolios forego the benefits of diversification
2. There's a margin for error in asset allocation. Being off by 10-20% from the optimal allocation doesn't significantly impact performance due to the diminishing returns along the efficient frontier.

Keeping It Simple: A Practical Approach

For most investors, including myself, building significant wealth through investing relies more on increasing investable income than on perfecting asset allocation. Rather than striving for an optimal portfolio, it's better to start with an improved investment policy:

• A 70:30 to 50:50 stock-to-bond ratio is reasonably close to optimal based on historical multi-period performance.
• This approach provides a solid foundation for long-term investing success.

In a future blog post, I plan to validate this claim using historical data using multiple periods, providing readers with concrete evidence to support this straightforward investment strategy.