- Diversification is a cornerstone of portfolio construction. It provides investors with the important ability to invest in the face of uncertainty. Because it can reduce risk without necessarily sacrificing potential reward, it is known as the only free lunch on Wall Street.
- Yet, we believe that many investors under-utilize a less well-known type of diversification: process diversification.
- When it comes to asset allocation, we regularly run across a “high conviction” bias whereby investors with their own approach to asset allocation are hesitant to incorporate complementary allocation strategies.
- The reason for this behavior seems to be a fear that adding managers with different approaches to asset allocation will dilute the investor’s own views.
- We believe that investors should blend a set of complementary, evidence-based asset allocation approaches (e.g. combining a strategic allocation with a momentum-based approach, a value-based approach, and a risk parity strategy), even if these different approaches regularly hold conflicting views about various asset classes. Doing so can capture the upside of each approach with less extreme allocation swings, better asset class diversification, and lower tracking error (an important consideration in managing client expectations).
Incorporating complementary processes reduces risk in two important ways.
- First, overall portfolio volatility will be lower. Why? Because as we saw previously, using multiple allocation processes reduces the likelihood of large bets on a subset of asset classes. This allows the overall portfolio to more consistently harvest available diversification opportunities.
- Second, tracking error will be lower. While this will indeed lower the chances for large outperformance, it will simultaneously lower the odds of large underperformance. In our view, managing this downside tracking error is crucial as it helps to control behavioral biases that can interfere with long-term investment success.
he list of evidence-based approaches is usually limited to some combination of the following:
- Strategic (e.g. balanced portfolios, 1/N, maximum Sharpe, etc.)
No allocation approach has an equal ex ante probability of success across all market environments. Evidence-based investment processes that are successful over the long-run can still go in and out of favor over extended periods of time.