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Bluford Putnam, the new president of Caisse des Depots et Consignations (CDC) Investment Management Company (NY), describes how to approach optimal portfolios
Over long periods of time the allocation of scarce capital resources among broadly defined asset classes can be the most critical decision determining investment performance and financial success. As the time horizon lengthens, such as when one takes a decade by decade perspective, the importance of the asset class allocation decision is emphasized even more.
The 1970s, for example, were a decade of rising inflation in almost all industrial countries. Bond markets suffered greatly in this environment, year after year, while commodity markets rallied. By contrast, the dis-inflationary 1980s were the mirror image of the 1970s, with rising bond prices and falling commodity prices. Also, the nifty-fifty stock market rally in the 1960s was reversed in the 1970s. The go-go equity markets of the 1920s were followed by the Great Depression of the 1930s. Decade by decade, the evidence is conclusive that last decade's winning investment strategy may be the big loser in the next.
For investors, as the turn of the century approaches, there are new challenges. Central banks and government have made great strides in reducing inflation to low levels. If the period of dis-inflation is coming to an end, however, should bond allocations be reduced? Also, as the world economy becomes increasingly integrated, there is the perception that correlations between major equity and bond markets are rising, effectively reducing the benefits of diversification in global portfolios. What is the appropriate asset allocation response to rising market correlations?
Optimal portfolios are a moving target
Using a"next step" approach to asset allocation decision making, this article will attempt to shed some light on the next big asset allocation moves that investors should be considering. The conclusions may seem obvious -- reduce bond exposures as inflation risks rise and search for alternative asset classes to combat rising correlations between traditional markets. The "next step" thought process, however, is quite general and can be applied to many other asset allocation questions to provide more robust answers than pure portfolio optimization techniques.
One goal of the investment manager is to design a portfolio that has appropriate risk and return objectives when compared with...