Beyond the 60/40 Rule: How Merton’s Theory Optimizes Asset Allocation

A brilliant article by The Economist explores probabilities, risk management, and investment strategies for your hard-earned savings. In a simple, insightful, and compelling way, it revisits a half-century-old investment theory by Robert C. Merton, based on his paper "Lifetime Portfolio Selection Under Uncertainty: The Continuous-Time Case." Merton’s model challenges the traditional 60/40 portfolio rule, instead advocating for an optimal asset allocation based on an investor’s individual risk aversion. Using the Constant Relative Risk Aversion (CRRA) utility function and your risk aversion, his framework determines the ideal split between high-risk assets (stocks) and safe assets (bonds) to maximize returns. In essence, Merton suggests that the percentage allocated to risky assets should be equal to their excess expected return over the risk-free alternative, divided by both personal risk aversion and the square of the risky asset’s volatility. This approach leads to a more dynamic asset allocation, adjusting as these variables change. Take a few minutes to digest this—I'll need more than a couple myself. While the theory offers a sophisticated and theoretically sound approach, applying it in practice is not straightforward. It requires precise estimations of key variables and may involve positions that some investors are unwilling or unable to take (such as short-selling). Additionally, one must be aware of and willing to accept the underlying assumptions and trade-offs. Interestingly, studies suggest that this investment strategy has stood the test of time, potentially delivering a significant premium over the conventional 60/40 approach. I must admit that, despite holding an MSc in Finance, I had never come across this theory before. It has certainly piqued my interest, and I plan to explore it further to see if it can be applied to my portfolio management. Hope you enjoy the article as much as I did! (text revised by a LLM) How much happiness does money buy? https://www.economist.com/christmas-specials/2024/12/19/how-much-happiness-does-money-buy from The Economist

- Pedro

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