A Modern, Behavior-Aware Approach to Asset Allocation and Portfolio Construction

42 Pages Posted: 2 Jun 2017

See all articles by Corey Hoffstein

Corey Hoffstein

Newfound Research

Justin Sibears

Newfound Research

Nathan Faber

Newfound Research

Date Written: December 5, 2016

Abstract

Diversification has been the cornerstone of investing for thousands of years as evidenced by timeless proverbs like “don’t put all your eggs in one basket.” The magic behind diversification – and one of the reasons it is considered the only “free lunch” available in investing – is that a portfolio of assets will always have a risk level less-than-or-equal-to the riskiest asset within the portfolio.

Yet it was not until Dr. Harry Markowitz published his seminal article “Portfolio Selection” in 1952 that investors had a mathematical formulation for the concept. His work, which ultimately coalesced into Modern Portfolio Theory (MPT), not only provided practitioners a means to measure risk and diversification, but it also allowed them to quantify the marginal benefit of adding new exposures to a portfolio and to derive optimal investment portfolios. For his work, Dr. Markowitz was awarded a Nobel prize in 1990.

The theory, however, has its shortcomings. The assumptions that asset class returns are normally distributed and that expected returns, volatilities, and correlations are both known to investors and are static over time fail to hold up to empirical evidence. Unfortunately, these assumptions appear to fail spectacularly during market crises: the very times that investors rely on diversification the most.

In light of these shortcomings, some have begun to question the merits of asset class diversification and MPT. With the benefit of perfect hindsight, the diversified portfolio will never be return optimal. It will always contain asset classes that disappoint. To judge the outcome of diversification after the fog of uncertainty has lifted, however, misses the point. Diversification is valuable precisely because investors don’t know what the future holds. We can be vaguely right instead of precisely wrong.

Nevertheless, we believe there are pragmatic improvements that can be made to address some of the MPT’s flaws. In our opinion, the most glaring of these flaws is the failure to acknowledge the role of investor behavior in long-term investment results.

Despite his foundational research in MPT, even Dr. Markowitz has admitted to forgoing its application within his own personal investments for behavioral reasons. “Instead, I visualized my grief if the stock market went up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”

Today, investors are presented with a larger palette of asset classes than ever before. The rise of nontraditional asset classes, the expansion of sub-asset classes, and the proliferation of mutual funds and exchange traded funds (ETFs) provide investors with new diversification opportunities wrapped in low-cost, liquid packages.

This paper outlines our views about the appropriate asset mix for different types of investors and explains our process for constructing a diversified portfolio that includes many of these new diversification opportunities. Most importantly, it highlights the steps that can be taken within asset allocation to address the behavioral shortcomings of investors. Our ultimate goal is to acknowledge that the optimal investment plan is, first and foremost, the one the investor can stick with.

Keywords: Modern Portfolio Theory, Behavioral Finance, Asset Allocation

JEL Classification: C00, C10, C50, G00, G11, G12

Suggested Citation

Hoffstein, Corey and Sibears, Justin and Faber, Nathan, A Modern, Behavior-Aware Approach to Asset Allocation and Portfolio Construction (December 5, 2016). Available at SSRN: https://ssrn.com/abstract=2881609 or http://dx.doi.org/10.2139/ssrn.2881609

Corey Hoffstein (Contact Author)

Newfound Research ( email )

425 Boylston Street 3rd Floor
Boston, MA 02116
United States
6175319773 (Phone)

HOME PAGE: http://www.thinknewfound.com

Justin Sibears

Newfound Research ( email )

425 Boylston Street
3rd Floor
Boston, MA 02116
United States

Nathan Faber

Newfound Research ( email )

425 Boylston Street
3rd Floor
Boston, MA 02116
United States

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