- 27 Kas 2020
- Tepkime puanı
Using asset allocation strategies as a form of risk management is not a new concept. The idea of "not putting all your eggs in one basket" is something we learned as children and has been around for thousands of years. Still, the term asset allocation within the investment community did not exist until recently. Even before the emergence of modern financial markets, people understood that one's assets must be divided into different classes, such as land, ownership of a business, and reserves (cash). The concept of asset allocation as a fact of life remained relatively unchanged until the mid-20th century.
So what has changed to create the asset allocation models we are familiar with today? In 1952, an American economist named Harry Markowitz wrote an article in the Journal of Finance entitled “Portfolio Selection” in which he developed the first mathematical model that emphasizes the reduction of volatility in a portfolio by combining investments with different return models. This article laid the foundation for what will become a standard in portfolio management known as "Modern Portfolio Theory".
Prior to Markowitz's contribution to the asset allocation of portfolios, diversification was a process that focused on the return and risk characteristics of individual securities regardless of how the returns relate to each other. After Markowitz created his mathematical models for portfolio building, his ideas quickly gained acceptance in academic circles. Numerous studies have been published confirming the benefits of asset allocation, and it quickly became popular among financial professionals.
(ERISA) was enacted as a federal law that sets minimum standards for investment allocations in retirement plans. Following the enactment of ERISA, asset allocation and modern portfolio theory have become standard practices for portfolio managers who must comply with the Law when allocating investor capital to pension plans for portfolio managers.
Modern Portfolio Theory (MPT) Concepts and Assumptions
Modern Portfolio Theory (MPT) has a significant influence on the way portfolio managers create their investment portfolios. The MPT concept is pretty straightforward. However, it requires the investor to make a few assumptions about the financial markets; Additionally, the mathematical equations used to calculate correlation and risk can be somewhat complex.
The basic premise of MPT is simple: By combining highly correlated securities from different asset classes, it can reduce portfolio volatility and increase risk-adjusted performance. In other words, combining unrelated assets will produce the most efficient portfolio - the portfolio with the highest return for a given amount of risk.
There are periods of low correlation or even negative correlation within this time period. By investing in both US domestic stocks and international stocks, overall volatility can be reduced as the correlation changes sufficiently to provide meaningful diversity between the two asset classes. The MPT concept shows that adding a variable asset to a portfolio can reduce overall volatility if returns have differences in correlation. This is an intriguing concept - that overall portfolio volatility can be reduced by bringing together asset classes with higher volatility returns on their own.
The assumption is that by combining asset classes that cannot be perfectly correlated when an asset depreciates, another asset in the portfolio increases in value over the same period. So even if all asset classes are quite variable on their own, volatility decreases when combined into a single portfolio.
The chart below shows an example of an extreme negative correlation compared to the US Dollar's Gold price over the past five years. If an investor had invested in these two variable assets together, the overall volatility of the portfolio would have decreased significantly due to the negative correlation.