Diversification and Portfolio Construction: Maximizing Return and Minimizing Risk

Abstract

Part 1 looked at different boxes of investment types individually, almost as though an investor would expect to find their one ideal investment in one of those boxes. This first chapter in Part 2 looks at how indices combine assets within a box to most efficiently earn returns from that box. Often, investors can expect better return and risk metrics by combining different assets with low or negative correlation with one another (i.e. ones that are at least as likely to move in opposite directions as they are to move up and down together). This chapter may be one of the most computationally intensive and technical in trying to provide one of the most accessible introductions to mean-variance analysis and optimization, but walks through the essential calculation in stock vs bond allocation that so many asset allocations get wrong. This chapter then finishes with the execution question by explaining the difference between implementing asset allocation through a top-down or bottom-up manner.