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The future remains as murky as ever, but the questions are becoming increasingly obvious.

Let's start with three. There are many more, of course, but these three seem particularly topical and therefore, knowing the answers to the following questions/topics, really would be immensely helpful for enhancing investment returns and all but eliminating risk. Unfortunately, that would require financial and economic clarity, both of which remain in short supply.

There's always a delicate balance of risk and reward, of course, and it's always laden with mystery as to what comes next. But the current outlook carries a bit more potential for each. So it goes in moments of distress and transition. In theory, asset allocation may warrant more extreme strategies when (and if) the valuations become immoderate. On the other hand, if valuations are generally middling, the case remains strong for broad diversification among the asset classes.

For the moment, broad diversification remains the more compelling choice, but the potential for something more extreme can't be ruled out in 2008. In fact, the debate tied to questions/topics below seems likely, in our view, to cast a long shadow on the asset allocation opportunities that await:

  • The first is Chinese inflation. The Associate Press reported that consumer prices in China are now at their highest levels in 11 years. Given the growing influence of the country in the world economy, investors should consider the implications if Chinese inflation continues rising. Indeed, China's economy has been a critical force in exporting disinflation for the past decade; the question is whether the country has the capacity for exporting the opposite?

  • Another subject on our mind is the U.S. economy and whether it's headed for recession, or just a period of unimpressive growth. The answer will matter a great deal to the bond market, which seems intent on pricing Treasuries in anticipation of recession. If that forecast turns out to be misguided, the fixed-income set will suffer and long rates will rise, perhaps sharply. On the other hand, some analysts say the bond market's right: tough times are coming and rates are headed lower.

  • The outlook for the world economy may determine if the bull market in commodities still has legs. History suggests that when growth slows, or certainly when it turns negative, commodity prices tumble. Oil is usually on the leading edge here. By that standard, there's little sign in the price of crude that the global growth is set to tumble. Oil, at nearly $100 a barrel, has rarely been higher. Of course, there's no shortage of fear that the economies of U.S. and Europe are due to downshift.

  • As the world learns more about where we're headed on the trio of subjects above, it may be possible to rationalize a more extreme asset allocation if — and a big "if" — valuations become compelling in one or more asset classes. We'll keep you posted.

    In the meantime, broad diversification, along with a cash overweight, still look like the best deal in town. For today, at least. But don't nap for too long. As the academics have been telling us for years now, expected returns for asset classes drift. The trick is catching them when they're relatively high. That day will come, but history suggests that it'll arrive on a first-come, first-serve basis. Stay tuned.

    Source: Broad Diversification Is Still the Best Game in Town