By: Justin Frankel and Jeremy Berman - Wavecrest Asset Management

Behavioral finance studies have shown that investors tend to substantially overestimate their tolerance for risk.  Most traditional balanced portfolio strategies rely on diversification between different asset classes to mitigate risk exposure, but for wealthy investors, building a portfolio around different risk categories may be a better solution to risk management.

Traditional balanced portfolios still have a concentration of risk in the allocation to equities.  Even when multiple asset classes are added (commodities, alternatives), these asset allocation decisions are based on the correlation of those assets to equities or to each other.  Disciples of efficient markets believe that market participants always act rationally and information is immediately reflected in market prices.  Using this assumption, investors typically seek portfolios constructed to be diversified across many different asset classes, in order to absorb market gyrations.  Unfortunately, recent history suggests that this theory is not bulletproof.  Andrew Lo, a professor at MIT, is credited with posing a different theory, the adaptive markets hypothesis.  This theory suggests market participants are not always perfectly rational, and often make bad decisions.  This theory allows for periods of extreme market volatility, during which time many asset classes become highly correlated.  If asset classes become more correlated during a crisis, and you think this is more indicative of the current market environment, a new approach to mitigating risk is needed.

During periods of extreme volatility, investors often make panicked and emotionally driven decisions that negatively impact performance.  Portfolio diversification should be designed to provide protection against a broad range of potential outcomes.  Achieving this diversification comes at a cost, usually in the form of less upside participation during bull markets.  More importantly, it also means less downside exposure during bear markets.  Avoiding the worst of bad markets allows investors to recoup total losses more quickly. From a psychological perspective, the avoidance of pain should reduce the possibility of panic selling.  Since asset class diversification is not enough to prevent catastrophe, we believe that the risk itself should be diversified. 

Institutions are already starting to rethink their investment process in order to address the problems of increased correlation.  Recently, Institutional Investor reported that CalPERS (California Public Employees' Retirement System) is changing its allocation framework into five new categories: Liquidity / Growth/ Income/ Real Assets/ Inflation-linked Assets. Instead of allocating based on asset classes, they are allocating based on risk categories. They believe that the new structure will improve risk management.

Certain investments do better than others at different points in a market cycle.  Our goal in portfolio construction is to look at specific risks and create zones of protection to buffer against them.  Think of your portfolio as a multi-lane highway.  During intense rush hour traffic, some lanes move while others do not.  This can be infuriating if you always feel like you are in the wrong lane, which can lead to frequent lane changes with terrible timing. Ultimately, the more times you change lanes, the less likely you will time it correctly, leading to a slower trip.  Proper diversification should be like having a car in each lane.  No matter which lane is moving, you are moving.  While it's impossible to be in many cars at the same time, it is possible to be in many investments at the same time.

In an environment where so much is interrelated, asset class diversification is not enough to prevent wealth destruction. Irrational behavior leads to volatility across all asset classes, making it necessary to diversify against systemic and structural risks. Keynes is credited with saying, "When the facts changes, I change my mind. What do you do, sir?" The global economic landscape has changed. Greater connectivity throughout the world and the faster pace of information flow has had disruptive effects on the markets. We think a new investment environment requires new theories that take a more proactive approach to managing risk.

Justin Frankel & Jeremy Berman have over 20 years of combined institutional experience trading, building, and marketing structured investments and equity derivatives. They are the founders and managing partners of Wavecrest Asset Management, and recently managed different components of the structured investments business at Morgan Stanley. They believe a disciplined approach to risk-managed investing leads to smoother returns and less volatility, and manage both a hedge fund and separate accounts based on this investment philosophy.

By: Pauline Johnson-Brown - Corcoran Group

New York is the city that never sleeps and neither does its real estate market-at least not for long. In 2008, New York City real estate fell from proverbial grace, losing its position as a can't-lose, guaranteed to appreciate investment. Now, Manhattan brokers are optimistic that the market is facing a turning point. Even as the recession forced most of the nation to endure a prolonged lull in home sales, Metro New York's housing market showed persistent signs of life. Whether selling a starter studio in a fourth floor walk up, or a luxury townhouse on the Upper East Side, each signed contract since the fall of Lehman Brothers, stood for one more vote of confidence in the everlasting value of New York.

With historically low interest rates and stabilized housing prices, Manhattan's luxury real estate market, including properties valued over $4 million dollars, presents buyers, brokers, and lenders a window of opportunity. Seeing signs of sustainable economic recovery, many investors peered into their stock portfolios, and feeling more flush than they did in the days following Lehman's collapse, made their move. They want to buy while the prices are hot and the lenders have freed up credit.

Due to a limited supply of the most sought after product, high end properties in particular have held value well. The high-end buyer is not only looking for a smart buy, but also the top quality amenities and finishes afforded by New York's luxury lifestyle. With the right address, buying in Manhattan still says, "I've arrived." Add historically low mortgages rates to Wall Street bonuses, and those well-heeled buyers have made quick work of absorbing much of New York's top tier housing stock.

Real Estate specialists anticipate that competition for top-quality product will only increase from here. Not only do we have the influx of buyers looking for bargains, we have fewer projects coming to the market as well. As a result, demand for the luxury real estate product is greater than supply, and in many cases causing bidding wars that drive up prices. 

Today, sales activity continues to see positive momentum. According to the Corcoran Group's Manhattan Monthly Snapshot of February 2011, market-wide sales increased in February, with Condo sales up 21% and co-op sales up 35% from January. Moreover, the market-wide average price per square foot reached an average of $1,167.  This is the highest average price per square foot that Manhattan property has demanded since just before the market turned in August 2008.

There are encouraging signs for the housing market. Still, regardless of economic fluctuations, New York is never a dull market. Our city is resilient because our product is unparalleled. The diversity, the energy, and the opportunity we offer is distinctly New York, and that's an asset appreciated by all types, across the globe and in this economic climate.

John Jacob Asto's quote says it all: "If I could live all over again, I would buy every inch of Manhattan."

Pauline Johnson Brown is an Associate Broker at the Corcoran Group, located at 660 Madison Avenue, New York. Pauline has been in the business of real estate brokering, as well as buying and selling for her own account, both nationally and internationally since 1982.