zaterdag 7 april 2018

Time Diversification as a way to improve terminal value?

Interesting piece, food for thought

Time diversification is ignored in most standard models in finance, which fail to account for impacts on terminal value from deviations in risks from target levels over the investment period, which we call excess risk. This excess risk significantly reduces compound returns and terminal value by magnifying convexity costs.

The form of excess risk that most negatively impacts terminal value is left-tail risk. Conversely, right-tail risk results in the largest increases in terminal value. As such, we believe that investors would benefit from adaptive asset allocation that focuses on outsized moves – reducing portfolio risk when downside tail risk increases and increasing portfolio risk when upside tail risk increases. This approach exhibits strong time-series diversification, and convexity gains, especially relative to other common asset allocation approaches. Moreover, cross-sectional diversification must not be forgotten. While the benefits of cross-sectional diversification disappear during a crisis, wherein seemingly unrelated assets exhibit high correlations, the benefits from managing micro-shocks are clear in non-crisis periods.

We believe that changing the focus from relative performance measurement and benchmarking to an adaptive asset allocation approach, which takes into account the changing risks of the benchmarks and their components, will manage portfolio risks more efficiently and enhance terminal value, and do so more consistently over time.
source: cfa website thinks it is important to add that time diversification has been the subject of spirited debates for decades. This piece origines from the cfa site and is written or influenced by Myron Scholes, if I am correct. In the debate in favour of time diversification we meet Jeremy Siegel ("Stocks for the Long Run", 1994). In Camp "No to time diversification" we read Paul Samuelson's "The long term case for equities and how it can be oversold" (1994). More question marks to the strategy come from Mark Kritzman's "What practitioners need to know about time diversification" (1994). 

Interesting to know is that the "No" camp has the believers of the random walk assumption and the more supportive camp (Yes) are the mean reversion believers. In a paper of Vanguard, "Time diversification and horizon-based asset allocation" you learn more about the pro's and con's, including the practitioners way. Given the fact that there is little evidence to fully support the notion of time diversification.

Commom sense in this active way of investing in risky assets is to get out of equities (0r decrease its weigth) as soon as volatility increases to levels of excess risk. To end the blog with a bang I will redirect you to the site of "wikihow" to...avoid being shot which helps you avoid being shot. Which seems to me a striking parallel. Because, once the trigger is pulled, it is nearly impossible to "dodge a bullet".

Decrease your risk profile or use your correlation watch

Preserving terminal wealth with time diversification works as long as prices are not too much of a random walk. In that case you should be prudent, run for cover or look for other ways of protection. In financial terms this means, be meticulous in defining your risk profile, protect your risk assets or invest in a well managed investment that has low correlation with your traditional asset classes.

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