ValidFi's  Instablog

If done it right, diversification, however, is still the most effective way to reduce risks. The following are the three key issues to construct such a portfolio.
 

1. Diversify across many asset classes: as stated above, even though most asset classes were correlated during the 2008 crisis, the few bright spots were US treasuries (especially the long term treasury bonds), GNMA and gold. For example, the static or ‘lazy’ portfolio proposed by Yale’s David Swensen in his book Unconventional Success: A Fundamental Approach to Personal Investment allocates 15% US treasury bonds (such as Vanguard long term treasury bond index fund VUSTX) as insurance against sudden market crisis (the other 15% in inflation protected bonds such as Vanguard’s VIPSX as inflation hedge in the total 30% fixed income allocation). This has alleviated some big loss for the portfolio in 2008.  Interested readers could find more information from the portfolio validfi.com maintains here. Diversification in diverse assets is the first step.  We encourage readers to at least consider the major asset classes and the ETFs or index funds in the table at the end of this article.  
2. Tactical asset allocation:  simply holding an array of diverse assets statically is not effective to reduce the systemic risk. The next step is to adopt tactical asset allocation, i.e. change asset allocation mix as market condition changes. The following are some strategies:
   • Follow great asset allocation investors: it is hard, if not possible, to predict asset trends. One way is to rely on third party recommendation on asset allocations. For example, Charles Schwab regularly recommends the asset weighting based on their market outlook. The recommendations are limited to stocks and sometimes general bonds. It is also unclear how effective those recommendations have been in the past. The other way is to identify some great investors or funds in asset allocation and follow their actions. ValidFi maintains a service called Guru Asset Allocation Watch to allow users to monitor Gurus like John Hussman (HSGFX), Jeremy Grantham's GMO Alpha Only III (GGHEX), Steven Leuthold's Core Fund (LCORX), Ivy Asset Management's Asset Strategy (WASAX) and PIMCO All Asset (PASDX) managed by Rob Arnott in Research Affiliated.
   • Use market timing to safe guard against market loss:  Many people have mistaken market timing technique as a simple ‘all in and all out’ single asset trading technique. In fact, applying market timing properly in a diversified portfolio has been effective to reduce risk and thus increase risk-adjusted return dramatically. For example, in his Seeking Alpha article, Mebane Faber proposed using 10 month moving average to safely guard each asset in a diversified portfolio. Such a portfolio has performed relatively well. Readers could find more detailed information and up to date performance in a strategy maintained by validfi.com.
   • Use cross asset momentum: It is well known that momentum driven investment strategy has worked reasonably well in the past (but sometimes, it is still subject to whipsaws due to side way movement). However, momentum across diverse assets has been doing even better due to the mega trends often exhibited in major asset movement. Several academic studies have also confirmed this. Interested readers could find out more information from strategies like Goldman Sachs Global Tactical Asset Allocation on validfi.com.
3. Diversify across various strategy styles: we could further diversify by choosing different styles of strategies in asset allocation and individual asset investing. For example, one could choose one or multiple equity (stock) strategies in the equity portion of the portfolio. Just as in a static portfolio, it is important to choose strategies which are uncorrelated (aside from good returns) to further reduce risk. Try to avoid choosing similar styles. For example, a momentum based strategy tends to do well in a trendy market but not well in a range bound market. In fact, an equity based momentum strategy did very poorly in 2005 but did a super job in 2008 (for a long short momentum strategy). If such a momentum strategy is chosen, it makes sense to mix it with other strategy styles such as a value based or a long short hedge strategy (such as covered call strategy) to hedge each other. Multiple strategies could be also chosen for other assets such as commodities and fixed income. We will have more follow up articles on this subject.

The methods discussed above have been well practiced by large pension funds, funds of hedge funds and other institutions. The success lies in proper diversification over asset classes and multiple investment strategies.