Risk matters. October’s wild stock market swings have reminded investors that volatility can be painful. They simply can’t stomach as much risk as they thought they could.

It’s no surprise that Professor André F. Perold’s October 21 talk on “Risk Stabilization and Asset Allocation” attracted a bigger than usual crowd to the monthly meeting of the Boston chapter of the Quantitative Work Alliance for Applied Finance, Education, and Wisdom, affectionately known as QWAFAFEW.

Perold’s premise: A stable-risk portfolio that keeps risk constant is a viable alternative to investors’ classic static policy portfolio, such as 60% stocks and 40% bonds, and it may offer superior risk-adjusted returns.

Perold brings both academic and applied experience to his topic. In addition to serving as the George Gund Professor of Finance and Banking at Harvard Business School, he also chairs the investment committee of HighVista Strategies, an investment firm with $1.7 billion under management that offers an endowment-style strategy to endowments, foundations, and qualified families. He also serves on the board of The Vanguard Group.

Asset Allocation Should Reflect Changing Levels of Risk

Static asset allocations make sense if expected returns, risks, and correlations for asset classes are constant. But these all change over time. Time-varying risk for portfolios can be seen in measures of stock market volatility and shifts in stock-bond correlations that run the gamut from positive to negative. For example, the market goes through periods of extended calm as it did between 2003 and May 2007 (see the data for the VIX options index below), but there are also crazy times, like October 2008. Last month included one day when  the S&P 500 moved up and down by more than 5% six times, and the market at one point moved 12% within 30 minutes.

As for stock-bond correlations, they’ve been negative during periods of stable inflation, when real interest rates drive bond prices, and positive during periods of inflation uncertainty, like we are facing today.

In his talk, Perold questioned whether, in an environment of shifting risk, a traditional static asset allocation can fulfill its goal “to make efficient tradeoffs between broad asset class risk and expected returns.” After all, he said, “When asset class risks and correlations are time-varying, the risk of a static allocation is also time-varying.” Investors can feel certain that a 60-40 portfolio is safer than a 70-30 portfolio and riskier than a 50-50 portfolio, but—because risk levels fluctuate—they don’t know the portfolio’s actual level of risk.

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