The Cake/Fruit Salad Theory of Asset Allocation

When you make a cake, you start out with a bunch of dry powdery white stuff (flour, sugar, baking powder, salt), some eggs, and some butter. And when you’re finished, the final product doesn’t look anything like those ingredients with which you began. It’s magic. The whole is greater than the sum of its parts.

And if you mess it up even a little bit (e.g., you leave out a teaspoon of baking powder) it can be a disaster.

Many people in the investment industry will tell you that asset allocation is like baking a cake. If you get it just right, in precisely this way (and definitely not that way), you’ll have something magical.

Some people become well known by promoting their own recipe (which does of course look amazing in the backtests).

But 5, 10, or 15 years later, what you’ll typically see is that the recipe turned out not to be magic. If the person is still in the industry, they’re now promoting a different recipe. The magic ingredient that five years ago was apparently the key is now, for some reason, not included in the portfolio. The magic ingredient/asset class is now just quietly left out (in favor of something else) because it’s no longer helpful in the backtests.

The thing to understand is that asset allocation is not like baking a cake.

Asset allocation is like making a fruit salad.

If you put in more blueberries, nothing magical happens, nor is there any disaster. Your fruit salad just has more blueberries. We can’t even say whether that’s necessarily a good thing or a bad thing; it depends entirely on how you feel about blueberries.

If you add more risky stuff, okay, now your portfolio is a little riskier. If you add more safe stuff, okay, now your portfolio is a little safer. That’s it. There’s no magic (except in backtests).

And if you choose to have just 3-4 ingredients in your fruit salad instead of 7, that’s fine. It will still get the job done.

There’s no one single recipe that beats the others. There are plenty of functional recipes. And you don’t have to be super precise about it — a little more or less of something than you had intended is not a disaster.