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Asset Allocation

Release Date: 2021/07/01
ISBN: 9781119817710
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Discover a masterful exploration of the fallacies and challenges of asset allocation

In Asset Allocation: From Theory to Practice and Beyond—the newly and substantially revised Second Edition of A Practitioner’s Guide to Asset Allocation—accomplished finance professionals William Kinlaw, Mark P. Kritzman, and David Turkington deliver a robust and insightful exploration of the core tenets of asset allocation.

Drawing on their experience working with hundreds of the world’s largest and most sophisticated investors, the authors review foundational concepts, debunk fallacies, and address cutting-edge themes like factor investing and scenario analysis. The new edition also includes references to related topics at the end of each chapter and a summary of key takeaways to help readers rapidly locate material of interest.

The book also incorporates discussions of:

  • The characteristics that define an asset class, including stability, investability, and similarity
  • The fundamentals of asset allocation, including definitions of expected return, portfolio risk, and diversification
  • Advanced topics like factor investing, asymmetric diversification, fat tails, long-term investing, and enhanced scenario analysis as well as tools to address challenges such as liquidity, rebalancing, constraints, and within-horizon risk.

Perfect for client-facing practitioners as well as scholars who seek to understand practical techniques, Asset Allocation: From Theory to Practice and Beyond is a must-read resource from an author team of distinguished finance experts and a forward by Nobel prize winner Harry Markowitz.

Table of Contents

  1. Cover
  2. Title Page
  3. Copyright
  4. Foreword to the First Edition
  5. Preface
  6. Key Takeaways
    1. Chapter 1: What Is an Asset Class?
    2. Chapter 2: Fundamentals of Asset Allocation
    3. Chapter 3: The Importance of Asset Allocation
    4. Chapter 4: Time Diversification
    5. Chapter 5: Divergence
    6. Chapter 6: Correlation Asymmetry
    7. Chapter 7: Error Maximization
    8. Chapter 8: Factors
    9. Chapter 9: 1/N
    10. Chapter 10: Policy Portfolios
    11. Chapter 11: The Private Equity Leverage Myth
    12. Chapter 12: Necessary Conditions for Mean-Variance Analysis
    13. Chapter 13: Forecasting
    14. Chapter 14: The Stock–Bond Correlation
    15. Chapter 15: Constraints
    16. Chapter 16: Asset Allocation Versus Factor Investing
    17. Chapter 17: Illiquidity
    18. Chapter 18: Currency Risk
    19. Chapter 19: Estimation Error
    20. Chapter 20: Leverage Versus Concentration
    21. Chapter 21: Rebalancing
    22. Chapter 22: Regime Shifts
    23. Chapter 23: Scenario Analysis
    24. Chapter 24: Stress Testing
  7. CHAPTER 1: What Is an Asset Class?
    1. STABLE AGGREGATION
    2. INTERNALLY HOMOGENEOUS
    3. EXTERNALLY HETEROGENEOUS
    4. EXPECTED UTILITY
    5. SELECTION SKILL
    6. COST-EFFECTIVE ACCESS
    7. POTENTIAL ASSET CLASSES
    8. REFERENCES
    9. NOTES
  8. CHAPTER 2: Fundamentals of Asset Allocation
    1. THE FOUNDATION: PORTFOLIO THEORY
    2. PRACTICAL IMPLEMENTATION
    3. THE SHARPE ALGORITHM
    4. REFERENCES
    5. NOTES
  9. CHAPTER 3: The Importance of Asset Allocation
    1. FALLACY: ASSET ALLOCATION DETERMINES MORE THAN 90% OF PERFORMANCE
    2. THE DETERMINANTS OF PORTFOLIO PERFORMANCE
    3. THE BEHAVIORAL BIAS OF POSITIVE ECONOMICS
    4. THE SAMUELSON DICTUM
    5. THE BOTTOM LINE
    6. RELATED TOPICS
    7. REFERENCES
    8. NOTES
  10. CHAPTER 4: Time Diversification
    1. FALLACY: TIME DIVERSIFIES RISK
    2. SAMUELSON'S BET
    3. TIME, VOLATILITY, AND PROBABILITY OF LOSS
    4. TIME AND EXPECTED UTILITY
    5. WITHIN-HORIZON RISK
    6. A PREFERENCE-FREE CONTRADICTION TO TIME DIVERSIFICATION
    7. THE BOTTOM LINE
    8. RELATED TOPICS
    9. REFERENCES
    10. NOTES
  11. CHAPTER 5: Divergence
    1. FALLACY: VOLATILITY SCALES WITH THE SQUARE ROOT OF TIME, AND CORRELATION IS CONSTANT ACROSS RETURN INTERVALS
    2. EXCESS DISPERSION
    3. THE EVIDENCE
    4. THE INTUITION
    5. THE MATH
    6. IMPLICATIONS
    7. THE BOTTOM LINE
    8. RELATED TOPICS
    9. REFERENCES
    10. NOTES
  12. CHAPTER 6: Correlation Asymmetry
    1. FALLACY: DIVERSIFICATION IS SYMMETRIC
    2. CORRELATION MATHEMATICS
    3. CORRELATION ASYMMETRY BETWEEN ASSET CLASSES
    4. IMPLICATIONS FOR PORTFOLIO CONSTRUCTION
    5. THE BOTTOM LINE
    6. RELATED TOPICS
    7. REFERENCES
    8. NOTES
  13. CHAPTER 7: Error Maximization
    1. FALLACY: OPTIMIZED PORTFOLIOS ARE HYPERSENSITIVE TO INPUT ERRORS
    2. THE INTUITIVE ARGUMENT
    3. THE EMPIRICAL ARGUMENT
    4. THE ANALYTICAL ARGUMENT
    5. THE BOTTOM LINE
    6. RELATED TOPICS
    7. REFERENCES
    8. NOTES
  14. CHAPTER 8: Factors
    1. FALLACY: FACTORS OFFER SUPERIOR DIVERSIFICATION AND NOISE REDUCTION
    2. WHAT IS A FACTOR?
    3. EQUIVALENCE OF ASSET CLASS AND FACTOR DIVERSIFICATION
    4. NOISE REDUCTION
    5. THE BOTTOM LINE
    6. RELATED TOPICS
    7. REFERENCES
    8. NOTES
  15. CHAPTER 9: 1/N
    1. FALLACY: EQUALLY WEIGHTED PORTFOLIOS ARE SUPERIOR TO OPTIMIZED PORTFOLIOS
    2. THE CASE FOR 1/N
    3. SETTING THE RECORD STRAIGHT
    4. EMPIRICAL EVIDENCE IN DEFENSE OF OPTIMIZATION
    5. PRACTICAL PROBLEMS WITH 1/N
    6. BROKEN CLOCK
    7. THE BOTTOM LINE
    8. RELATED TOPICS
    9. REFERENCES
    10. NOTE
  16. CHAPTER 10: Policy Portfolios
    1. FALLACY: POLICY PORTFOLIOS MATTER
    2. RISK INSTABILITY
    3. WHAT INVESTORS WANT
    4. RESPONDING TO RISK REGIMES
    5. THE BOTTOM LINE
    6. RELATED TOPICS
    7. REFERENCE
  17. CHAPTER 11: The Private Equity Leverage Myth
    1. FALLACY: PRIVATE EQUITY VOLATILITY SCALES WITH ITS LEVERAGE
    2. THE PRIVATE EQUITY LEVERAGE PUZZLE
    3. LEVERAGE AND VOLATILITY IN THE PUBLIC EQUITY MARKET
    4. THE BOTTOM LINE
    5. RELATED TOPICS
    6. REFERENCES
    7. NOTES
  18. CHAPTER 12: Necessary Conditions for Mean-Variance Analysis
    1. THE CHALLENGE
    2. DEPARTURES FROM ELLIPTICAL DISTRIBUTIONS
    3. DEPARTURES FROM QUADRATIC UTILITY
    4. FULL-SCALE OPTIMIZATION
    5. THE CURSE OF DIMENSIONALITY
    6. APPLYING FULL-SCALE OPTIMIZATION
    7. THE BOTTOM LINE
    8. RELATED TOPICS
    9. REFERENCES
    10. NOTES
  19. CHAPTER 13: Forecasting
    1. THE CHALLENGE
    2. CONVENTIONAL LINEAR REGRESSION
    3. REGRESSION REVISITED
    4. PARTIAL SAMPLE REGRESSION
    5. THE BOTTOM LINE
    6. RELATED TOPICS
    7. REFERENCES
    8. NOTE
  20. CHAPTER 14: The Stock–Bond Correlation
    1. THE CHALLENGE
    2. SINGLE-PERIOD CORRELATION
    3. FUNDAMENTAL PREDICTORS OF THE STOCK–BOND CORRELATION
    4. MODEL SPECIFICATION
    5. MODEL RESULTS
    6. THE BOTTOM LINE
    7. RELATED TOPICS
    8. REFERENCES
    9. NOTES
  21. CHAPTER 15: Constraints
    1. THE CHALLENGE
    2. WRONG AND ALONE
    3. MEAN-VARIANCE-TRACKING ERROR OPTIMIZATION
    4. THE BOTTOM LINE
    5. REFERENCE
    6. NOTE
  22. CHAPTER 16: Asset Allocation Versus Factor Investing
    1. THE CHALLENGE
    2. PORTFOLIO CONSTRUCTION
    3. CASE STUDY
    4. THE BOTTOM LINE
    5. RELATED TOPICS
    6. REFERENCES
    7. NOTES
  23. CHAPTER 17: Illiquidity
    1. THE CHALLENGE
    2. SHADOW ASSETS AND LIABILITIES
    3. EXPECTED RETURN AND RISK OF SHADOW ALLOCATIONS
    4. OTHER CONSIDERATIONS
    5. CASE STUDY
    6. THE BOTTOM LINE
    7. RELATED TOPICS
    8. APPENDIX
    9. REFERENCES
    10. NOTES
  24. CHAPTER 18: Currency Risk
    1. THE CHALLENGE
    2. WHY HEDGE?
    3. WHY NOT HEDGE EVERYTHING?
    4. LINEAR HEDGING STRATEGIES
    5. NONLINEAR HEDGING STRATEGIES
    6. THE BOTTOM LINE
    7. RELATED TOPICS
    8. REFERENCES
    9. NOTES
  25. CHAPTER 19: Estimation Error
    1. THE CHALLENGE
    2. TRADITIONAL APPROACHES TO ESTIMATION ERROR
    3. STABILITY-ADJUSTED OPTIMIZATION
    4. BUILDING A STABILITY-ADJUSTED RETURN DISTRIBUTION
    5. DETERMINING THE OPTIMAL ALLOCATION
    6. EMPIRICAL ANALYSIS
    7. THE BOTTOM LINE
    8. RELATED TOPICS
    9. REFERENCES
    10. NOTES
  26. CHAPTER 20: Leverage Versus Concentration
    1. THE CHALLENGE
    2. LEVERAGE IN THEORY
    3. LEVERAGE IN PRACTICE
    4. THE BOTTOM LINE
    5. RELATED TOPICS
    6. REFERENCES
    7. NOTES
  27. CHAPTER 21: Rebalancing
    1. THE CHALLENGE
    2. THE DYNAMIC PROGRAMMING SOLUTION
    3. THE MVD HEURISTIC
    4. THE BOTTOM LINE
    5. RELATED TOPICS
    6. REFERENCES
    7. NOTES
  28. CHAPTER 22: Regime Shifts
    1. THE CHALLENGE
    2. PREDICTABILITY OF RETURN AND RISK
    3. REGIME-SENSITIVE ALLOCATION
    4. TACTICAL ASSET ALLOCATION
    5. THE BOTTOM LINE
    6. APPENDIX: BAUM–WELCH ALGORITHM
    7. RELATED TOPICS
    8. REFERENCES
    9. NOTES
  29. CHAPTER 23: Scenario Analysis
    1. THE CHALLENGE
    2. COMPARISON TO MEAN-VARIANCE ANALYSIS
    3. THE MAHALANOBIS DISTANCE APPLIED TO SCENARIO ANALYSIS
    4. THE MAHALANOBIS DISTANCE AND PROBABILITY
    5. REVISING PROBABILITIES
    6. CASE STUDY
    7. MAPPING ECONOMIC VARIABLES ONTO ASSET CLASS RETURNS
    8. THE BOTTOM LINE
    9. RELATED TOPICS
    10. REFERENCES
    11. NOTES
  30. CHAPTER 24: Stress Testing
    1. THE CHALLENGE
    2. END-OF-HORIZON EXPOSURE TO LOSS
    3. WITHIN-HORIZON EXPOSURE TO LOSS
    4. REGIMES
    5. THE BOTTOM LINE
    6. RELATED TOPICS
    7. REFERENCES
    8. NOTES
  31. CHAPTER 25: Statistical and Theoretical Concepts
    1. DISCRETE AND CONTINUOUS RETURNS
    2. ARITHMETIC AND GEOMETRIC AVERAGE RETURNS
    3. STANDARD DEVIATION
    4. CORRELATION
    5. COVARIANCE
    6. COVARIANCE INVERTIBILITY
    7. MAXIMUM LIKELIHOOD ESTIMATION
    8. MAPPING HIGH-FREQUENCY STATISTICS ONTO LOW-FREQUENCY STATISTICS
    9. PORTFOLIOS
    10. PROBABILITY DISTRIBUTIONS
    11. THE CENTRAL LIMIT THEOREM
    12. THE NORMAL DISTRIBUTION
    13. HIGHER MOMENTS
    14. THE LOGNORMAL DISTRIBUTION
    15. ELLIPTICAL DISTRIBUTIONS
    16. THE MAHALANOBIS DISTANCE
    17. PROBABILITY OF LOSS
    18. VALUE AT RISK
    19. UTILITY THEORY
    20. SAMPLE UTILITY FUNCTIONS
    21. ALTERNATIVE UTILITY FUNCTIONS
    22. EXPECTED UTILITY
    23. CERTAINTY EQUIVALENTS
    24. MEAN-VARIANCE ANALYSIS FOR MORE THAN TWO ASSETS
    25. EQUIVALENCE OF MEAN-VARIANCE ANALYSIS AND EXPECTED UTILITY MAXIMIZATION
    26. MONTE CARLO SIMULATION
    27. BOOTSTRAP SIMULATION
    28. REFERENCES
    29. NOTES
  32. Glossary of Terms
  33. Index
  34. End User License Agreement
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