Many of the methods used to predict risk and return in the capital markets assume that tomorrow’s market will look much the same as yesterday’s market and that statistical relationships will remain constant. For Modern Portfolio Theory, the risk management process is constructing a portfolio with the lowest possible risk (standard deviation) for a given level of expected return. Constructing a portfolio using this method relies heavily on the assumption that correlations between the investments within the portfolio will remain constant. In reality, these relationships do not always remain constant. Consider the image below illustrating a significant increase in asset class correlations during the financial crisis.
Modern Portfolio Theory as a stand-alone risk management tool attempts only to weather the storm. It will not get you out of disaster's way. (It also completely neglects to account for any element of human behavior.). Fortunately, there are asset allocation models designed to identify and mitigate the risk in changing market environments. The Dynamic Asset Level Investing (DALI) Tool serves as the backbone for these tactical strategies. In a nutshell, DALI aggregates relative strength relationships across five macro asset classes to produce a ranking from strongest to weakest. Unlike diversification-only risk management, DALI’s effectiveness does not rely on the persistence of historical relationships; it is based on the forces of supply and demand currently present in the market. DALI will not just help weather the storm, it can actually provide the red flashing "evacuate" signal.
All of this is not to say that diversification can't provide a benefit to portfolios over time, but rather that we recognize it cannot appropriately serve as the only risk management tool. Combining a tactical asset allocation strategy within a strategic asset allocation framework can help position a portfolio against disaster. Should the skies open up in the future, we know that while we cannot protect against all potential damage, we have options beyond simply "weathering the storm."
Until next time, cheers!