The Three Pillars of Better Strategic Portfolios
We think a common sense definition of diversification is the degree to which long-run portfolio outcomes are determined by a multitude of unrelated drivers. This paper explores three dimensions, or three pillars, that we think maximize an investor’s probability of success in strategic asset allocation: diversification within asset classes, across asset classes and across time.
Most investors have taken to heart that holding a combination of risk assets and bonds can improve the Sharpe ratio of their portfolios. However, most investors never fully consider diversification as a way to potentially improve the odds of achieving high target portfolio returns because, in most investors’ minds, diversification leads to lower return. Risk parity breaks the link between diversification and lower return by using moderate leverage to convert a more efficient portfolio into one that is designed to generate high return at an acceptable level of risk.