In October 2011, Russell Investments published a paper proposing the use of a dynamic asset allocation policy that varies as market volatility changes. They carefully explained that the volatility as measured by the standard deviation of a sample portfolio that was 50% equities and 50% bonds (using the Russell 3000 Index for equities and the Barclays Capital US Aggregate Bond Index for bonds) was, on average, 8.4%. But they also showed that the standard deviation of that portfolio varied considerably over time: over 13% at its high and below 4% at its low.

The key takeaway that came from their analysis was that volatility was, by itself, volatile. In addition, they suggested that using historical averages for volatility in asset allocation ignores the foundation of strategic asset allocation which is the trade-off between risk and return. As an example, let’s look at the following portfolios and their hypothetical average returns and average standard deviations:

An investor may tell his advisor that he is willing to accept the lower return of a 40% / 60% (equities/bonds) portfolio because the volatility of the portfolio is nearly 25% lower than the 60% / 40% portfolio. But we have to remember that these numbers are historical averages. What happens when we look at annualized volatility numbers which are significantly different than historical averages? Will that investor want to be in a 40%/60% portfolio when the annualized standard deviation moves up to close to 11.5% like it did in 2008-2009? Or will he want to reduce his equity exposure dynamically as the volatility of his portfolio increases?

Rationalis Capital Management has taken this analysis one-step further and focused on the volatility of each asset class in a portfolio. Most portfolios contain allocations to many different asset classes. We utilize Index Funds and ETFs to gain exposure to Large Cap Stocks, Small Cap Stocks, Real Estate funds, Commodities, Gold, International Stocks and Foreign Currencies to name a few. We focus our efforts on understanding the changing risk patterns in each asset class we introduce to our portfolios. It is by studying these patterns that we respond to the fundamental trade-off between risk and reward by increasing exposure to assets when volatility is low and decreasing exposure when volatility is high.