After citing his work on Monday, we spent some time reading Ben Inker's recent white paper on diversification, portfolio design, and asset class valuation. This is very good stuff, a timely reminder that valuation determines medium- and long-term investment returns--and that diversification across risky asset classes won't do much to limit losses when most or all of those risky asset classes had become similarly overvalued. (We riffed on this topic back in January.)
There's much more in this paper than we can cite here, so please register at GMO.com and read the whole thing. But here's a very telling paragraph (emphasis added in bold):
Here and elsewhere, the key variable is the price one pays to acquire a financial asset. In 2007, risky assets were all expensive. And the rest is recent history.
There's more, in particular the ways in which diversification across (and, implicitly, within) asset classes plays out over varying time horizons.
If you crave sentences such as "The period from 2003-07 was probably the Golden Age of the covariance view of risk for institutional investors," this is the paper for you. Speaking for ourselves, we do, and it is.
Ben Inker, "When Diversification Failed," Grantham Mayo Van Otterloo & Co., December, 2008 (registration required)