Emerging Markets in an Upside Down World: Challenging Perceptions in Asset Allocation and Investment

Chapter 8

Asset Allocation

‘We tend to get it wrong when the accumulated experiences and beliefs derived from the past do not provide a correct guide to future decision-making. There are two reasons … not correctly comprehending what is happening to us … (and) an inability to make the necessary institutional adjustments.’

North (2005, p. 117)

Our Martian friend whom we introduced in the box at the beginning of Chapter 5 reached some conclusions about risk but also about asset allocation, which is the high-level process of how we decide what sort of things we are going to invest in and in what proportions. He noticed several things about how asset allocation is often practised:

1. Risk is poorly understood.

2. Uncertainty is ignored.

3. Herd mentality is rife.

4. The set of asset classes is fairly arbitrary and static.

5. Indices dominate thinking in defining asset classes and asset allocation.

6. There is a circular logic to investing in line with (market-cap weighted) index weightings: the more investors invest in an asset class, the bigger the market cap of the index, the greater incentive they have to invest there.

7. Asset allocation is given a high degree of prominence over manager selection by many institutional investors – the theory to back this up again has a circular logic as EMH is assumed (i.e. that managers cannot beat indices consistently) to lead to a conclusion that … managers cannot beat indices consistently.

8. The debate over passive versus active management ...