Kinlaw et al., A Practitioner’s Guide to Asset Allocation

William Kinlaw, Mark P. Kritzman, and David Turkington have written a carefully researched book that reaches sometimes counterintuitive (or at least counter to common wisdom) conclusions. A Practitioner’s Guide to Asset Allocation (Wiley, 2017) is directed at professional investors and advisors, but some of the material might be useful to systematic traders as well. Although the authors rely on quantitative analysis, they do not overwhelm the reader with math and statistics. For those who need a brief refresher course to understand the gist of the text, there is a chapter late in the book explaining basic statistical and theoretical concepts.

Among the misconceptions the book sets out to rectify are:

1. Asset allocation explains more than 90% of investment performance.

2. Investing over long horizons is less risky than investing over short horizons.

3. Factors offer greater potential for diversification than asset classes.

4. Equally weighted portfolios perform better out of sample than optimized portfolios.

The authors explore such questions as whether, to increase expected return, it’s preferable to apply leverage to a less risky portfolio than to concentrate a portfolio in riskier assets, as theory holds. Answer: “what is inarguable theoretically does not always hold empirically when we introduce more plausible assumptions.”

They also address the thorny problem of regime shifts. They investigate three approaches to managing risk (using volatility as a proxy for risk): stability-adjusted optimization, regime-sensitive asset allocation, and tactical asset allocation based on regime indicators. They suggest that the first two approaches “yield static portfolios that most likely will still experience wide swings in their volatility.” Tactical asset allocation is more flexible, and “although this additional flexibility may not always improve performance, we have provided encouraging evidence to suggest that some investors might profit from tactical trading, given the right insights and methods.”

There’s a lot of meat in this book. Investors and advisors who devote time to it, especially those with some quant skills, will come away enriched.