It's very easy, using conventional asset allocation techniques, to allow your portfolio outcomes to be dominated by a concentrated influence like the stock market. Many investors understand that even a portfolio that appears broadly diversified from a capital perspective — say, a traditional 60% equity/40% bond mix — has a very unbalanced risk allocation, with nearly 90% of portfolio risk driven by the performance of equities.
So big idea No. 1 is that a better approach to allocating assets is to think about how your overall return is influenced by sensitivities to the individual component parts of a portfolio, and to try to keep those sensitivities in balance — not let any asset class have an outsized and unintended effect on portfolio returns. That is the basis of many traditional risk parity strategies, and most of the time, that is an advantageous way to organize your asset allocation.
Big idea No. 2 recognizes that there are certain market environments when risk-balanced approaches to asset allocation are not optimal. One clear and common example being an environment in which the risk and return profiles of the constituent portfolio building blocks (stocks, bonds, etc.) are lopsided. When some assets look strong and other assets look weak, it makes better sense to emphasize those investments that look strong. Another example is an environment in which all the portfolio components appear equally unattractive and could decline simultaneously, like during the taper tantrum in the summer of 2013. In such a circumstance, diversification, either capital- or risk-based, doesn't help you very much.
Big idea No. 3 synthesizes these first two observations, and posits that evidence-based research can provide tools for anticipating those conditions when balanced risk investing may be sub-optimal. When those exceptional conditions are flagged, we don't merely tweak our existing portfolio, we shift completely to a different asset allocation more suited to the new environment.