Asset Allocation facts and fallacies

• A large number of studies using time series over differing periods demonstrate that the markets and asset allocation together have an R-squared value hovering around 0.8 (i.e. markets and asset allocation account for around 80% of the variability in returns of a portfolio comprised of asset classes), with the remaining variability explained by active management (timing, selection, tactical allocation).


• Combining asset classes with low correlation to one another improves the portfolio risk/return characteristics. Returns are more stable as the overall volatility is smoothened. Although the return calculation is the sum of the weighted returns of the constituents of the portfolio, the volatility calculation includes a correlation factor in its formula which is determined by the covariance values of the constituents.
  
• Time horizon is key when evaluating the performance of an asset allocation portfolio. The weight allocation to the various asset classes determine the risk profile of the portfolio and hence the time horizon of the investments. Evaluating performances over periods that are substantially shorter than the time horizon can be extremely misleading and damaging to performance over the longer term, as it subjects the decision making process to random noise.


• Correlations amongst asset classes can spike during periods of systemic risk (as in 2008) which can lead to a temporary breakdown in the risk/return characteristics of the underlying portfolio. It should be noted that such events tend to occur over relatively short periods as markets adjust themselves to new valuations that more closely reflect their respective intrinsic values, for example following the burst of a financial bubble.


• An asset class is defined as a group of investment instruments that share similar traits in terms of their structure and their risk and return characteristics. In order to constitute an asset class, it should be possible to calculate the intrinsic value of its members. For stocks, for example, the dividend discount model is used to calculate the present value of the expected future stream of cash flows of the company. Although commodities are typically treated as a separate asset class, it is impossible to calculate its intrinsic value as no future cash flow stream is involved. Price is determined by the forces of demand/supply.


• Diversification amongst asset classes is the only known effective method of countering the inherent randomness of markets. Although it is "future" proof, it is certainly not "fool" proof and therefore can and should be complemented by other techniques such as portfolio insurance to mitigate the sometimes ravaging effects of negative fat tails.

A "Black Swan" week...

During last week two particular events occurred that squarely belong to the "black swan" category.
Iceland's volcanic ashes spread across Europe, shutting down the airspace for most countries, leaving passengers stranded and further exacerbating the recovery of a weak and struggling airline industry. As no one was really prepared for this event and as no one really knows until when the European airspaces will remain closed (it will largely depend on the forces of nature), stocks of major airlines have taken a nose dive over the last couple of days. The repercussions could extend further into the European economy that is already struggling with a major debt crisis.
On a similar note, Friday's news that the U.S. Securities and Exchange Commission would be investigating the "venerable" Goldman Sachs for alleged fraudulent behavior led a major blow to a firm that, until then, had been boasting on its ability to boost the bottom line in any type of market condition. Again, no one was prepared, unless, of course, someone had access to insider information on the matter and decided to trade on it, which, in any case, would constitute fraud in most jurisdictions. The financial sector also took a nose dive with shares of Goldman losing close to 13% over a single day.
Although these two events are perfect examples of "black swans", I would like to emphasize that a "black swan" event can also very well be a positive one (these two examples just happen to be negative events) that would have the effect of lifting markets.
It should also be noted that positive and negative events don't carry the same weight in the human mind. According to studies on behavioral finance, a negative event can carry up to 2.5 times the impact on our psyche that a positive event would. Food for thought.

Degrees of certainty...

When facing speculators, the amount of information disclosed can make the difference between succeeding or blowing up. Take currency pegs as an example. Typically, you have two types of pegs, the "clean" type whereby a declared exchange rate is defended by the government and the more frequent "dirty" type, better known as a "dirty float" where the currency is allowed to fluctuate within a narrow band. The problem with clean pegs are that they are extremely difficult to defend because there is a very small margin for error. The slightest fluctuation in the exchange rate could trigger an onslaught of the speculators who could interpret such information as meaning that the government does not have sufficient reserves to defend the peg.

With a dirty float, on the other hand, certainty is replaced by uncertainty as a slight deviation in the exchange rate could simply be the result of noise and therefore unrelated to the government's capability of defending the peg. Uncertainty in this instance provides a clear advantage in defending a currency peg.

It is interesting to note that these observations are in complete accordance with studies on human psychology. In one famous experiment, students were broken into two groups and subjected to mild electric shocks. The first group received an audio cue which was randomly combined with the electric shock, whilst the second group would receive the shock once every tenth audio cue. The blood pressure and brainwave activities of both groups were measured. Unsurprisingly, the first group were permanently stressed, as they could not figure out when they would receive the next shock, whilst in the case of the second group, the stress level would only start building up after the eighth or ninth audio cue.

The human mind is not very good at coping with uncertainty but, like the currency peg example above, there are instances where uncertainty can be used as a very effective weapon. There are also instances where the contrary is true. Take the Greek debt crisis as an example. The European Union thought that the simple declaration that they would intervene if need be would suffice to keep speculators at bay. Wrong! The markets apparently did not take their word at face value, forcing them into disclosing the exact terms of the bailout. The markets seem to have reacted favorably to this additional "valuable" information but it is still too early to say if it will suffice to salvage what seems to be a sinking ship. The "black swan" adage would argue that just because such a default has never been observed in the past certainly does not mean it will never happen.