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.