Asset Allocation Design and Care of Portfolios
WILLIAM J. BERNSTEIN, Ph.D., M.D. Coprincipal and Cofounder, Efficient Frontier Advisors
Harry Markowitz (1952), in writing in the Journal of Finance, fired “the shot heard around the world,” a 15-page article unobtrusively titled “Portfolio Selection,” in which he suggested that rational investors were concerned not only with maximizing return but also with minimizing volatility. In other words, if there is more than one portfolio that returns 10 percent per year, then the optimal one is that which has the lowest volatility, with variance being his designated proxy for volatility. More obviously, the converse is also true: If there are multiple portfolios with a given volatility, then the one with the highest return is the optimal one. Put another way, the investor should always be willing to trade off some return for a reduction in risk or take additional risk in order to get a larger return. For risk-averse investors, the ratio of incremental required return to risk is large; and for risk-tolerant ones, small.
Much has been made of a landmark trio of papers by Gary Brinson and several colleagues (1986, 1991, 1995) that demonstrated that over 90 percent of the variance of portfolio return was explained by the allocation among three different asset classes: stocks, bonds, and cash by pension funds. Later, Jahnke (1997) pointed out that this rather artificial and constrained example overstated the importance of the policy ...