William Kinlaw - Asset Allocation

1 Cover

2 Title Page Asset Allocation From Theory to Practice and Beyond WILLIAM KINLAWMARK KRITZMANDAVID TURKINGTON

3 Copyright

4 Foreword to the First Edition

5 Preface

6 Key TakeawaysChapter 1: What Is an Asset Class? Chapter 2: Fundamentals of Asset Allocation Chapter 3: The Importance of Asset Allocation Chapter 4: Time Diversification Chapter 5: Divergence Chapter 6: Correlation Asymmetry Chapter 7: Error Maximization Chapter 8: Factors Chapter 9: 1/N Chapter 10: Policy Portfolios Chapter 11: The Private Equity Leverage Myth Chapter 12: Necessary Conditions for Mean-Variance Analysis Chapter 13: Forecasting Chapter 14: The Stock–Bond Correlation Chapter 15: Constraints Chapter 16: Asset Allocation Versus Factor Investing Chapter 17: Illiquidity Chapter 18: Currency Risk Chapter 19: Estimation Error Chapter 20: Leverage Versus Concentration Chapter 21: Rebalancing Chapter 22: Regime Shifts Chapter 23: Scenario Analysis Chapter 24: Stress Testing

7 CHAPTER 1: What Is an Asset Class? STABLE AGGREGATION INTERNALLY HOMOGENEOUS EXTERNALLY HETEROGENEOUS EXPECTED UTILITY SELECTION SKILL COST-EFFECTIVE ACCESS POTENTIAL ASSET CLASSES REFERENCES NOTES

8 CHAPTER 2: Fundamentals of Asset AllocationTHE FOUNDATION: PORTFOLIO THEORY PRACTICAL IMPLEMENTATION THE SHARPE ALGORITHM REFERENCES NOTES

9 CHAPTER 3: The Importance of Asset AllocationFALLACY: ASSET ALLOCATION DETERMINES MORE THAN 90% OF PERFORMANCE THE DETERMINANTS OF PORTFOLIO PERFORMANCE THE BEHAVIORAL BIAS OF POSITIVE ECONOMICS THE SAMUELSON DICTUM THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

10 CHAPTER 4: Time DiversificationFALLACY: TIME DIVERSIFIES RISK SAMUELSON'S BET TIME, VOLATILITY, AND PROBABILITY OF LOSS TIME AND EXPECTED UTILITY WITHIN-HORIZON RISK A PREFERENCE-FREE CONTRADICTION TO TIME DIVERSIFICATION THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

11 CHAPTER 5: DivergenceFALLACY: VOLATILITY SCALES WITH THE SQUARE ROOT OF TIME, AND CORRELATION IS CONSTANT ACROSS RETURN INTERVALS EXCESS DISPERSION THE EVIDENCE THE INTUITION THE MATH IMPLICATIONS THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

12 CHAPTER 6: Correlation AsymmetryFALLACY: DIVERSIFICATION IS SYMMETRIC CORRELATION MATHEMATICS CORRELATION ASYMMETRY BETWEEN ASSET CLASSES IMPLICATIONS FOR PORTFOLIO CONSTRUCTION THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

13 CHAPTER 7: Error MaximizationFALLACY: OPTIMIZED PORTFOLIOS ARE HYPERSENSITIVE TO INPUT ERRORS THE INTUITIVE ARGUMENT THE EMPIRICAL ARGUMENT THE ANALYTICAL ARGUMENT THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

14 CHAPTER 8: FactorsFALLACY: FACTORS OFFER SUPERIOR DIVERSIFICATION AND NOISE REDUCTION WHAT IS A FACTOR? EQUIVALENCE OF ASSET CLASS AND FACTOR DIVERSIFICATION NOISE REDUCTION THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

15 CHAPTER 9: 1/NFALLACY: EQUALLY WEIGHTED PORTFOLIOS ARE SUPERIOR TO OPTIMIZED PORTFOLIOS THE CASE FOR 1/N SETTING THE RECORD STRAIGHT EMPIRICAL EVIDENCE IN DEFENSE OF OPTIMIZATION PRACTICAL PROBLEMS WITH 1/N BROKEN CLOCK THE BOTTOM LINE RELATED TOPICS REFERENCES NOTE

16 CHAPTER 10: Policy PortfoliosFALLACY: POLICY PORTFOLIOS MATTER RISK INSTABILITY WHAT INVESTORS WANT RESPONDING TO RISK REGIMES THE BOTTOM LINE RELATED TOPICS REFERENCE

17 CHAPTER 11: The Private Equity Leverage MythFALLACY: PRIVATE EQUITY VOLATILITY SCALES WITH ITS LEVERAGE THE PRIVATE EQUITY LEVERAGE PUZZLE LEVERAGE AND VOLATILITY IN THE PUBLIC EQUITY MARKET THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

18 CHAPTER 12: Necessary Conditions for Mean-Variance AnalysisTHE CHALLENGE DEPARTURES FROM ELLIPTICAL DISTRIBUTIONS DEPARTURES FROM QUADRATIC UTILITY FULL-SCALE OPTIMIZATION THE CURSE OF DIMENSIONALITY APPLYING FULL-SCALE OPTIMIZATION THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

19 CHAPTER 13: ForecastingTHE CHALLENGE CONVENTIONAL LINEAR REGRESSION REGRESSION REVISITED PARTIAL SAMPLE REGRESSION THE BOTTOM LINE RELATED TOPICS REFERENCES NOTE

20 CHAPTER 14: The Stock–Bond CorrelationTHE CHALLENGE SINGLE-PERIOD CORRELATION FUNDAMENTAL PREDICTORS OF THE STOCK–BOND CORRELATION MODEL SPECIFICATION MODEL RESULTS THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

21 CHAPTER 15: ConstraintsTHE CHALLENGE WRONG AND ALONE MEAN-VARIANCE-TRACKING ERROR OPTIMIZATION THE BOTTOM LINE REFERENCE NOTE

22 CHAPTER 16: Asset Allocation Versus Factor InvestingTHE CHALLENGE PORTFOLIO CONSTRUCTION CASE STUDY THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

23 CHAPTER 17: IlliquidityTHE CHALLENGE SHADOW ASSETS AND LIABILITIES EXPECTED RETURN AND RISK OF SHADOW ALLOCATIONS OTHER CONSIDERATIONS CASE STUDY THE BOTTOM LINE RELATED TOPICS APPENDIX REFERENCES NOTES

24 CHAPTER 18: Currency RiskTHE CHALLENGE WHY HEDGE? WHY NOT HEDGE EVERYTHING? LINEAR HEDGING STRATEGIES NONLINEAR HEDGING STRATEGIES THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

25 CHAPTER 19: Estimation ErrorTHE CHALLENGE TRADITIONAL APPROACHES TO ESTIMATION ERROR STABILITY-ADJUSTED OPTIMIZATION BUILDING A STABILITY-ADJUSTED RETURN DISTRIBUTION DETERMINING THE OPTIMAL ALLOCATION EMPIRICAL ANALYSIS THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

26 CHAPTER 20: Leverage Versus ConcentrationTHE CHALLENGE LEVERAGE IN THEORY LEVERAGE IN PRACTICE THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

27 CHAPTER 21: RebalancingTHE CHALLENGE THE DYNAMIC PROGRAMMING SOLUTION THE MVD HEURISTIC THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

28 CHAPTER 22: Regime ShiftsTHE CHALLENGE PREDICTABILITY OF RETURN AND RISK REGIME-SENSITIVE ALLOCATION TACTICAL ASSET ALLOCATION THE BOTTOM LINE APPENDIX: BAUM–WELCH ALGORITHM RELATED TOPICS REFERENCES NOTES

29 CHAPTER 23: Scenario AnalysisTHE CHALLENGE COMPARISON TO MEAN-VARIANCE ANALYSIS THE MAHALANOBIS DISTANCE APPLIED TO SCENARIO ANALYSIS THE MAHALANOBIS DISTANCE AND PROBABILITY REVISING PROBABILITIES CASE STUDY MAPPING ECONOMIC VARIABLES ONTO ASSET CLASS RETURNS THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

30 CHAPTER 24: Stress TestingTHE CHALLENGE END-OF-HORIZON EXPOSURE TO LOSS WITHIN-HORIZON EXPOSURE TO LOSS REGIMES THE BOTTOM LINE RELATED TOPICS REFERENCES NOTES

31 CHAPTER 25: Statistical and Theoretical Concepts DISCRETE AND CONTINUOUS RETURNS ARITHMETIC AND GEOMETRIC AVERAGE RETURNS STANDARD DEVIATION CORRELATION COVARIANCE COVARIANCE INVERTIBILITY MAXIMUM LIKELIHOOD ESTIMATION MAPPING HIGH-FREQUENCY STATISTICS ONTO LOW-FREQUENCY STATISTICS PORTFOLIOS PROBABILITY DISTRIBUTIONS THE CENTRAL LIMIT THEOREM THE NORMAL DISTRIBUTION HIGHER MOMENTS THE LOGNORMAL DISTRIBUTION ELLIPTICAL DISTRIBUTIONS THE MAHALANOBIS DISTANCE PROBABILITY OF LOSS VALUE AT RISK UTILITY THEORY SAMPLE UTILITY FUNCTIONS ALTERNATIVE UTILITY FUNCTIONS EXPECTED UTILITY CERTAINTY EQUIVALENTS MEAN-VARIANCE ANALYSIS FOR MORE THAN TWO ASSETS EQUIVALENCE OF MEAN-VARIANCE ANALYSIS AND EXPECTED UTILITY MAXIMIZATION MONTE CARLO SIMULATION BOOTSTRAP SIMULATION REFERENCES NOTES

32 Glossary of Terms

33 Index

34 End User License Agreement

1 Chapter 2 TABLE 2.1 Expected Returns TABLE 2.2 Standard Deviations and Correlations TABLE 2.3 Optimal Allocation to Stocks and Bonds TABLE 2.4 Conservative, Moderate, and Aggressive Efficient Portfolios TABLE 2.5 Exposure to Loss TABLE 2.6 Distribution of Wealth 15 Years Forward (as a Multiple of Initial I...

2 Chapter 3 TABLE 3.1 Standard Deviation, Correlation, and Relative Volatility

3 Chapter 4 TABLE 4.1 Time, Volatility, and Probability of Loss TABLE 4.2 Expected Wealth and Expected Utility TABLE 4.3 Probability of a Within-Horizon 10% Loss

4 Chapter 5TABLE 5.1 Attribution of Excess Dispersion of Triennial Relative ReturnsTABLE 5.2 Monthly and Triennial Standard Deviations and Correlations

5 Chapter 6TABLE 6.1 Correlation Asymmetry of Mean-Variance and Full-Scale Optimal Portf...