During his recent interview with Money Talks, Cliff Asness explained how to harness the power of diversification. Here’s an excerpt from the interview:
Asness: There are a few things. I probably first leapt into this by responding to a Journal of Portfolio Management article back in the early ninety’s, and it was essentially that it was long term investors should be 100% in equities.
And I said, well what do they teach us kind of third week of finance class?
They draw this thing. Now, your listeners do not know I’m currently drawing an efficient frontier on my hand. They tell us you should own the best portfolio of risky assets in both stocks and bonds have some risk, and you should either gear it up or down by adding cash.
But you should always work from that best portfolio, and the gearing is to determine your risk level. And then in real life, people don’t seem to do that.
If they’re aggressive, they buy all equities, and if they’re conservative, they buy all bonds. If you take a diversified portfolio call it 60:40, and lever it to approximate equal risk to equities long term, because it’s less risky alone, you do get in fact about the same risk of equities and you outperform it because you’re harnessing the power of diversification.
You basically have a better portfolio for the risk taken. A broader question you asked is why do people undervalue diversification in general? And that’s hard to answer when someone says, why do people miss like, the most important thing in portfolio construction?
You can listen to the entire discussion here:
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