Practical Applications of Adaptive Portfolios and the Power of Diversification

Practical Applications Summary In Adaptive Portfolios and the Power of Diversification, in the August 2019 edition of The Journal of Investing, Jürgen Vandenbroucke of KBC Asset Management NV describes a discretionary method for portfolio management that addresses investor emotions at the individual, investment-product, and portfolio levels. By adding “a behavioral component to the prevailing risk-based paradigm,” he subscribes to the adaptive market hypothesis (Lo 2004), which concerns how individuals’ emotions may negate rational investment decision-making. Vandenbroucke highlights the common consequences of emotion-driven investing. He then proposes remedies in the areas of investor profiling, product positioning, and portfolio construction. He distinguishes between investor attitudes toward “risk,” as measured by the variance of returns, and “loss,” as measured in terms of an investment’s potential gain versus its potential losses. This amounts to operating beyond the confines of a classical mean–variance framework and considering the entire shape of the distribution of future returns (which may be non-normal). He differentiates among investment products along spectrums of mean versus variance and upside potential versus downside hazard. Finally, he shows how to weight selected investment products to align investors’ loss aversion with a balance between upside potential and downside risk in a portfolio. This weighting allows a portfolio to inhabit an investor’s “comfort zone” by adjusting its allocations as market conditions change. A customer-centered adaptive portfolio of this kind enhances diversification and can temper emotionally driven trading activity that would otherwise be a drag on performance. TOPICS: Wealth management, portfolio construction, statistical methods