There are two types of dynamic asset allocation: convergent and divergent.
Convergent approaches rely on mean reversion. Examples include CAPE ratio with equities, credit spreads, VIX (volatility) mean reversion, stat arb, most commodity prices, interest rate levels, and equity valuation spreads.
Divergent approaches bet on continuation. Examples include trend following, volatility targeting, buying out-of-the-money put options.
The two approaches differ in two challenges they are likelier to face: large crashes or low returns.
The Convergent approach leans on the side of larger crashes because of the ‘doubling down’ effect. Betting on mean reversion can result in increased drawdown. It’s the classic ‘catching falling knives’ analogy of buying deep value stocks as they continue to get cheaper. Convergent trades also have the risk of being too early (i/e ‘market can stay irrational longer than you can stay solvent’). Although convergent approaches appear prudent by buying at what appears as lower prices, they can make staying invested for the long-run harder than divergent ones.
The Divergent approach aims to mitigate the downside asset class risk by following the trend and getting out before the bottom is reached. Their goal is to help survive the crash without giving up (i.e. avoiding the highest cost in investing). Divergent trades tend to act as insurance for catastrophic left tails but have the risk of being late and the risk of low return: ‘the flat line’ caused by the whipsaw effect.
Even if investors’ asset allocation is not determined by a dynamic model, most ongoing changes to the sub-asset classes are either divergent or convergent.
For example, adding Gold last summer is a divergent approach. Removing longer-term treasuries a few years ago because the yields became low is a convergent approach.
Both examples result in material portfolio consequences that are beyond the accuracy of the individual trade. Investors end up adding or removing divergent / convergent exposures in the portfolio and, as a result, changing the types of risks they are exposed to.
Finding an optimal combination of the divergent and convergent approaches can lead to better asset allocation decisions.