The Journal of Portfolio Management
For investors, selecting the appropriate asset classes to be included in a portfolio is arguably the most important task, but the traditional analytical frameworks use only historical mean- variance analysis to identify asset classes and fail to look into the future. As a result, portfolios built using the traditional approach might not maximize value for investors.
This article introduces a new process, called investment consumption value (ICV), to determine the appropriate asset classes for investment based on the fundamentals of economics and finance. In a nutshell, because all investing is done to fulfill consumption need, this new concept looks into how consumers benefit from investment transactions.
In essence, the efficient portfolio is one that offers the best expected return and risk profile to meet the consumption desires associated with different investments or economic states.
Passive assets, such as commodities and alternative assets, should be considered suitable asset classes according to the concept of ICV. Passive assets are used as inputs in production and converted into other assets, and their intrinsic values are often difficult to measure.
We contend that commodities serve as insurance to protect against unexpected inflation, and including them in a portfolio will reduce overall volatility. Certain hedge fund strategies also add ICV as part of a portfolio.
Other nonfinancial sector investments, such as education and insurance policies, help reduce the need for precautionary savings, increase spending levels during a person’s lifetime, and contribute positive ICV. From an ICV perspective, risk should be thought of as the likelihood that portfolio goals will not be met.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.
This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.