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Veteran investors - otherwise known as anyone who's gotten burned at least once in the capital markets - are rightly skeptical when someone comes along and says they've got the money game figured out. Someone says that, or its equivalent, about once every three seconds these days.

The reasons for staying skeptical are no less legion. Suffice to say, the proof is in the pudding and so it's no accident that there's a huge spread between the number of people who claim to have the secret investing sauce and those who can point to some real-world evidence. With that in mind, you may want to take the following with a grain of salt as well. Your editor too is a card-carrying member of the mere mortals club.

We say that because even a judicious, enlightened approach to investment strategy (which, we humbly believe, is a label that applies to our approach to portfolio design) is laden with risks, both known and unknown. It's the latter that potentially pose the biggest dangers.

As an example, first consider a known risk, such as shunning diversification. Whether it's a particular asset class or a broad asset-allocation strategy, everyone knows (or should know) that concentration risk is easily avoided and so anyone who suffers at the hands of this particular demon probably hasn't been paying attention to the 50-years of financial research. That's not to say that one should never, under any circumstances, move away from complete diversification. But at the very least, know what you're getting into before jumping off the cliff.

Meanwhile, it's the unknown risks that keep us awake at night. By definition, this class of hazards is mysterious, of course, although we have some clues about how they materialize. Exhibit A is the evolving nature of markets, including the relationships between asset classes. It's all too easy to look back on history and draw tidy conclusions about how the capital and commodity markets interact with one another. But finance is not physics, and so yesterday's iron laws can and do turn into something less, something more or something entirely unfamiliar by yesterday's standards.

Here are two quick examples:

  • The relationship between the 10-year Treasury yield and commodities.
  • The extraordinary jump in spreads between the overnight inter-bank lending rate and the Libor rate.
  • Monday's Wall Street Journal observed that:

    After decades of moving up and down more or less in tandem, the relationship between commodity prices and bond yields has broken down, leaving a yawning gap between them.
    Simply put, the relatively high correlation of the 10-year Treasury yield and the CRB/Reuters Commodity Index has, in the last few years, faded significantly. The usual signals dispensed by this relationship, as a result, may now be of questionable value, if not wholly irrelevant. Unless of course the shifting relationship is a "bubble," in which case normality will one day return.

    Meanwhile, a new working paper posted on the San Francisco Fed's web site details the strange state of affairs of late in the money markets. According to "A Black Swan in the Money Market (pdf file)," it began last August, when

    the interest rate on overnight loans between banks—the effective federal funds rate—jumped to unusually high levels compared with the Fed’s target for the federal funds rate. Rates on inter-bank term loans with maturities of a few weeks or more surged as well, even though no near-term change in the Fed’s target interest rate was expected. Many traders, bankers, and central bankers found these developments surprising and puzzling after many years of comparative calm.

    The paper advises that, as we now realize, the August turmoil was

    the start of the start of a remarkably unusual period of tumult in the money markets, perhaps even qualifying as one of those highly unusual “black swan” events that Taleb (2007) has recently written about...

    There are numerous implications and explanations associated with the two examples. In fact, we could cite many more instances of how some bit of recent market activity doesn't conform with the historical record. Some of these "anomalies" are temporary, in which case fresh investment opportunities may be spawned. But some events that deviate from the perceived norm are enduring and so they signal a fundamental change in market structure. Figuring out which is which is devilishly difficult and for all practical purposes impossible. That doesn't mean we shouldn't try, but let's not kid ourselves that the future is any less cloudy simply because we have a full boat of data in our spreadsheet.

    In any case, we can't simply give up and leave our futures completely to fate. Fortunately, there are some enduring truths for strategic-minded investors. That starts with the default portfolio, which is the global market portfolio as determined by Mr. Market. For the average investor, this is the ideal portfolio. Of course, no one is the average investor and so we proceed to the second task: determining how we're different from the average investor, and how to translate that into a different asset allocation strategy relative to Mr. Market's portfolio.

    Here are a few quick examples to illustrate how this works. Assume an investor works in the energy industry, in which case a fair amount of the investor's future earnings are tied up with the expected fortunes and risks of the energy industry. In that case, there's a sound argument for owning a global equity index that lessens or strips out the energy industry exposure.

    Another reason for deviating from Mr. Market's portfolio is when an investor believes she has better information than the collective wisdom of investors. Let's say you're confident that REITs are undervalued, or that bonds are poised to suffer a bear market. In those cases, you may feel compelled to alter Mr. Market's asset allocation accordingly. Before you do, however, ask yourself: Am I supremely confident in my forecast? If not, you may want to reconsider.

    In the end, any portfolio strategy relies on some amount of faith, which is unsurprising since the future's largely unclear. But don't despair: the uncertainty of the morrow is the reason why there's a expected risk premium today. Absent the premium, there's no point to investing in the first place. On that point, we can all agree. But the consensus starts and ends there.

    Source: Mr. Market Keeps Investors Guessing