Outside the Box

The Role of Risk in Asset Allocation

November 2, 2012

Diversification of your investments is the only real free lunch, or so we are told. But how do we go about deciding what to diversify into? In this week’s short Outside the Box, my friend Jason Hsu of Research Affiliates argues that the real basis for diversification should be risk. And given that risk seems to be rising everywhere we look, thinking about how to deal with risk in our portfolios makes a great deal of sense.

I’m also including in today’s OTB a complementary piece by good friend Charles Gave of GaveKal. This is a short piece that is long on common sense and that winds up with a straightforward list of places where we can invest to minimize risk.

I am in Montevideo, Uruguay tonight. I finished my second speech this morning (the first was a few days ago in Sao Paulo) and have tried to talk to local businessmen and other people as much as possible. I will write about what I have learned at a later time, as I have been given much to think about. One thing I can say now is that I need to get down here more often. It really helps me think about crisis to be with people who have experienced the ups and downs of economic and political crises, often more than once. And on Saturday I go to Argentina, where my speech in Buenos Aires later next week has been changed to another day in order to not coincide with what shapes up as a major demonstration. I may get there in time to observe. It has been some time since I have been up close to a major demonstration. I have locals taking care of me, so I am not concerned, but I do admit to being a little curious.

By the way, Uruguay is booming. Full employment, construction everywhere, and everyone seems happy. And so far, everyone in Brazil and Uruguay I have met expects Obama to win in a landslide. I read where large majorities in Europe also think that way. And given what they read and hear, it is no wonder.

That has really got me thinking. I am going to write about the election this weekend, but not in the way you might think. This election offers a teaching opportunity about one of our biggest challenges as investors, and that is the problem with unreliable models that I have been writing about for the past three weeks. How can very smart people look at the same data and come to such different conclusions? Whether it is politics, investments, or the weather, there is a common theme and one that we very much need to be aware of if we hope to succeed with our investments goals.

It is time to hit the send button, as it is late here and Enrique Fynn is picking me up to start what will be a semi-vacation for the next five days. Tomorrow I go visit Punta del Este for a little fishing and touring, then enjoy a BBQ with friends at Enrique’s, and then on Saturday I’ll take the boat to Buenos Aires and fly out early Sunday morning to Salta and drive to Cafayate for a few days at La Estancia, hosted by my partners in Mauldin Economics. Tuesday night we’ll watch the elections, and we’ll get to see which polls were right. And then it’s back to BA on Thursday and home to Dallas on Saturday.

Have a great week!

Your thinking about where in the world to find alpha analyst,

John Mauldin, Editor
Outside the Box

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The Role of Risk in Asset Allocation

By Jason Hsu, Ph.D.

A traditional asset allocation framework allocates to various asset classes with the goal of matching important risk exposures. In reality, many asset classes share exposures to common risk factors and thus are highly correlated, particularly with equities. This article explains how investors can achieve more intuitive and perhaps more sensible portfolios with an approach based on risk factors.


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Derek Moore

Nov. 2, 2012, 5:16 p.m.

A great article by Charles.  A spark of light in a great ocean of darkness that passes for economic comment today.