A Framework For Taming 'Wildly Random' Markets

Includes: SGOL, SHY, SPY
by: CFA Institute Contributors

By Lauren Foster

Ashvin Chhabra, chief investment officer at the Institute for Advanced Study, is well known for his seminal 2005 article “Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors,” in which he reframed asset allocation through the lens of risk allocation while building on the central tenets of Modern Portfolio Theory and behavioral finance.

Ashvin B. Chhabra

Speaking on Monday at the 65th CFA Institute Annual Conference in Chicago, Chhabra reminded the audience that “asset allocation is a form of risk allocation.” He proposed a goals-based risk allocation framework for unstable markets as “a different way” to construct portfolios and understand markets.

In fact, in Chhabra’s view, risk allocation must precede asset allocation and the selection of managers and/or securities. His central thesis is that investors can manage risk more effectively by dividing their portfolios into three distinct buckets:

  • A “Personal Risk” Bucket, which is low risk and low return and emphasizes safety, while providing for a standard of living. This bucket includes “protective” assets such as cash, a home and mortgage, human capital, and safe investments such as short-duration U.S. Treasuries.
  • A “Market Risk” Bucket, which encompasses assets that deliver market-level returns. This is the place where index funds, speculative gold investments, and strategic investments belong.
  • An “Aspirational Risk” Bucket, in which investors can feel freer to take significant risk in order to potentially deliver sizeable wealth generation. This is the high risk and high return bucket and includes assets such as company stock, a business, private equity, or concentrated stock positions.

Chhabra argues that by dividing assets (as well as liabilities) into three buckets, the wealth allocation framework helps investors manage risk in relation to their goals.

Here are some additional takeaways from his session:

  • Market prices are based on economic and social interactions, which makes markets subject to prolonged periods of instability. When you account for the unstable nature of markets you need a safety net.
  • Financial markets, like floods, hurricanes, and other irregular and random phenomena in nature, are inherently unpredictable. Markets are not “mildly random, but wildly random,” said Chhabra, quoting Benoit B. Mandelbrot.
  • Investors’ expectations that the market will meet their financial goals are misplaced.
  • Long-term predictions are a fool’s game.
  • How long does it take to move up the wealth spectrum by pursuing a more aggressive (but still diversified) asset allocation? It takes more than 100 years to move from the 40th to the 60th percentile, according to Chhabra.
  • How do people achieve wealth mobility? It happens in various ways, all of which involve leverage and concentration.
  • Investors need to take fat tails very seriously. The challenge is that predicting them is impossible.