As we begin Chapter 2 of this book, it is worth restating our premise: asset allocation is basically the process by which assets are allocated between and among various investments based in part on investors’ expected risk and expected return of those investments. In addition, asset allocation is premised on judgment and experience. Quantitative tools and models are simply reference points in our quest. Just as we use a compass to tell us true north, we know and understand that it cannot tell us which particular road to take. If Chapter 1 is any guide, the truth is that almost 60 years after the introduction of Modern Portfolio Theory we are still struggling to find ways to precisely define and measure factors that affect expected returns. However, since expected return is based on risk (however it is measured), the real focus in asset allocation should be on defining, measuring, and managing risk. This chapter offers investors a better sense of what risk measurement is and what it is not, and just as important, what it can do and what it is not able to provide, that is, investment certainty.
In the previous chapter, we determined that the basic message of modern finance is that higher risk should in the long run lead to higher return. Therefore, risk estimation should be the primary driver in asset allocation for the simple reason that an asset ’s price and therefore its expected return is a function of its underlying risk. Expected risk drives expected ...