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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What Must Be True: Strategic Thinking for Managing Risk

Roger Martin, former Dean of the Rotman School, has written a fascinating and insightful article about risk management, emphasizing that a robust strategic process is the only effective way to approach it. Martin argues that, in most cases, risk management conducted by corporate boards often amounts to little more than box-ticking to comply with the Sarbanes-Oxley Act (S-OX) Section 404. This requirement, enacted after scandals like Enron and WorldCom, has become a lucrative exercise for consulting firms but provides little real value to management or investors. Instead of addressing critical risks, these efforts often generate exhaustive lists of potential risks (as seen in typical 10-K filings), which serve as "safe harbor" statements for management rather than actionable insights. A more effective way to approach risk management is by applying the Rumsfeld Risk Matrix (as illustrated in the accompanying graphic). This matrix divides risks into four quadrants: 1.Known Knowns – Risks we are aware of and understand well enough to measure and manage. 2.Known Unknowns – Risks we recognize but do not fully understand. 3.Unknown Knowns – Risks we are unconsciously aware of but fail to identify as risks. 4.Unknown Unknowns – Risks we are entirely unaware of. The ultimate goal of risk management is to increase awareness, turning unknowns into knowns, and improving precision by addressing uncertainties. This involves identifying key risks that are not fully understood, assessing their material impact and likelihood, and investing in understanding them better. It also requires implementing systems to monitor risks that might not be obvious and to uncover entirely new risks. So how is this achieved? The answer lies in a strong strategic process. A well-designed strategy explicitly considers what must be true (WWHTBT) for success and potential derailment, addressing factors such as industry dynamics, customer behavior, organizational capabilities, competitor actions, vendor dependencies, and technological advancements. By conducting thorough internal (IFE) and external (EFE) factor evaluations, along with a comprehensive SWOT analysis, organizations can identify key risk factors, enhance awareness, and improve their ability to detect unknown risks early. This article offers valuable insights and is highly recommended for anyone interested in strategic risk management. (text revised by a LLM) https://rogermartin.medium.com/risk-management-strategy-59869afd3558

- Pedro

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10 Trends to Watch in 2025: Insights from Tom Standage

10 Trends to Watch in 2025, Inspired by Tom Standage’s Insights 1-America First Redux Geopolitical shifts will unfold as the U.S. doubles down on its "America First" policy. 2-A Call for Change Macro-political transformations are imminent, driven by demands for reform in nearly every major election of 2024. 3-Heightened Instability in Europe and the Middle East A transactional approach from the new U.S. administration could exacerbate tensions in these regions. 4-The Tariff Tsunami Expect more tariffs, with ripple effects on global trade and economic growth. 5-The Clean-Tech Boom China's advancements in clean technology could revolutionize the energy sector worldwide. 6-Inflation and Fiscal Tightening Most economies are gearing up for stricter fiscal policies, raising questions about growth and voter approval. 7-The Politics of Aging Could age limits for political leaders become a global trend? 8-AI Revolution Agentic AI systems are poised to become the most transformative innovation since the internet. 9-Tourism Backlash The pushback against overtourism will reshape the travel industry. 10-Expect the Unexpected From global pandemics to solar storms, the world must brace for unpredictable disruptions. Stay tuned for a deeper dive into each of these trends in the near future. (text revised by a LLM) Tom Standage’s ten trends to watch in 2025 https://www.economist.com/the-world-ahead/2024/11/18/tom-standages-ten-trends-to-watch-in-2025 From The Economist

- Pedro

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The world ahead 2025 - Economist

The world ahead 2025 from the Economist. A must read, more on it in the near future. https://www.economist.com/topics/the-world-ahead-2025

- Pedro

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Review: Managing Risk and Uncertainty

Managing Risk and Uncertainty by Richard Friberg
My rating: 4 of 5 stars

I took a couple of days after reading this book to provide my rating and this review. I did it on purpose so i could mature the idea of what to write and how to rate it. Looking back it was a wise decision as the rating will be higher today if i did it immediately after (in fact would be a 3,5 stars).

I got this book by chance, while looking for books on risk, and the thing that made me read it was its synopsis and coming from MIT press, most probably I'm one of the few that did it (looking at goodreads jhistoric and even the information available on Amazon).

So why did i like it:
- Presented in an operational framework on how to think about risk and uncertainty and how to manage it, through different lenses and specific areas within a company;
- Ran through several areas related with risk & uncertainty (finance, economics, pricing, forecasting, behavioral science) explaining the basics and also disclosing the sources of it synthesis that allows a interested reader to deepen his knowledge in case he finds it appropriate (i will do it myself in a couple of areas);
- Disclosed the how the author thinks and approaches risks and uncertainty and you can use (always adding your critical reasoning and experience) to your day-to-day live. The 4 main strategies are a great starting point, at least how to structure it
- It requires (and can be a severe handicap for the ones not with sufficient literacy) at least a intermediate level of economic and finance knowledge to not get lost in quite a few areas. It made me revisit several concepts that i did not thought and operacionalize for a long time.

What i did not like:
- the books loses when it tries to be also a text book. Gets caught on the midst of a technical book with a specific body of knowledge, and a text book to support specific lectures on risk and uncertainty;
- The online resources are not currently available, that hamper the full resources that should be available;
- The examples that are quite good and insightful but could be complemented with additional examples (fully explained and resolved) and solution on the online resources.

I do think it was time worth spent reading it and for people that would like to broaden their horizons on this topic I do recommend its reading. I know that I will use specific areas of knowledge presented on my daily professional activity.


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Review: The Essentials of Risk Management, Second Edition

The Essentials of Risk Management, Second Edition by Michel Crouhy
My rating: 0 of 5 stars

Risk Management - Slightly more than the essentials

Good starting point to risk management. Although it can be read by an interested reader, you need to have advanced financial knowledge to fully grasp all its content, examples and situations presented.

The book is naturally skewed to the financial industry, as this sector is spearheading such endeavors, nonetheless all the knowledge and takeaways can be adapted for non-financial institutions.

The book sets the building blocks of Risk Management (and sometimes goes well beyond that). As an improvement suggestion, there should be more practical examples and the cases presented could have been more dissected from an analytical perspective to help the reader to consolidate the presented concepts and theory.



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Review: A Practical Guide to Risk Management

A Practical Guide to Risk Management by Thomas S. Coleman
My rating: 3 of 5 stars

Good insights about this complex and interesting topic. An introduction (doubts about the practicality),as a caveat you do need advanced knowledge in probabilities, statistics, and complex financial instruments to fully understand all the examples provided.

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