Asset allocation assets exhibit random covariance

Recently I read several books on asset allocation. This is not a full review of them, but I did notice several disturbing points.

One of the books wrote a lot about the variance between difference types of assets, such as stock and bonds. This variance is a critical point for asset allocation, because the theory behind it, Modern Portfolio Theory, comes from Harry Markowitz's work showing that overall portfolio risk is reduced by holding assets that don't go up and down in tandem.

Anyway, the book went on at length about how tricky this is, because the variance of stocks and bonds changes over time, and came up with different variances over 3 year periods in the past.

I had one of those flashes -- and it goes like this.

The stock market moves in a random walk.

The bond market moves in a random walk.

Therefore, whether stocks and bond prices go in different directions through various 3 years periods is . . . ta! da! --

Random.

I mean, at any given moment either market go only be going up, down or sideways. Therefore, sometimes they'll go in the same direction, sometimes they won't.

Yet this book wants you to adjust your allocation periodically on the basis of these random moves.

Look, the whole idea is that you're reducing risk because these two markets both are random, but can go in different directions. But it's obvious that sometimes they'll go in the same direction.

If you want uniformity, put your money in a passbook savings account in a bank.


asset allocation illusion
asset allocation illusion