Executive Summary
During the Global Financial Crisis, the cry went up from institutional investors around the world, “What the hell went wrong with my portfolio? I thought I was diversified.” Portfolios that seemed secure against any eventuality crumbled in the onslaught of the bear market, and many investors realized that their carefully crafted risk control measures had failed.
In this paper written as the GFC was roiling markets, Ben Inker outlines why we at GMO believe investors need to reassess the virtues of diversification among risk assets. While there are benefits to diversification, they are not quite the ones that many investors think. We also believe investors need to look beyond the standard quantitative risk models and recognize the kinds of risk that those models fail to capture. Quantitative risk analysis and “efficient frontier investing” gave investors a false sense of confidence before the GFC, taking them down a path that led to greater losses and more than a few bankruptcies. The paper also touches upon other key risks, such as timing and career risk that, again, is not captured in academic literature nor in modern portfolio management tools. To better protect portfolios against large drawdowns and increase long-term returns, Ben advises to look beyond static portfolios and risk models to a more dynamic asset allocation.