Excerpted from Mark Spitznagel’s book Safe Haven and narrated by Mark. Explains the Narrow Framing Problem as applied to investing.

By Nassim Nicholas Taleb
May 6, 2021
 
Santa Marina
 
In my ancestral village in the Northern Levant, on top of a hill, stands a church dedicated to Santa Marina. Marina is a local saint, though, characteristically, some other traditions claim her –such as Bithynia or other Anatolian provinces of the Eastern Roman Empire.
 
Marina grew up in a wealthy family, in the fifth century of our era. After the death of her mother, her father decided to turn his back to civil existence and embrace a life of monasticism. His aim was to spend the rest of his life in a cell carved in the rocks, in the Connubium (Qannubin) valley, at the base of Mount Lebanon, about eight miles from my village. Marina insisted on joining him and faked being a boy, Marinos.
 
About a decade later, after the death of her father, a visiting Roman soldier impregnated the daughter of a local innkeeper and instructed her to accuse the defenseless father Marinos of having committed the deed. The innkeeper’s daughter and her family complied, fearing retaliation by the Roman soldiers.
 
Marina took the blame –yet she did not need a tough litigator, to prove her innocence. She refrained from revealing her biological gender, to remain true to her monkhood identity and what she perceived to be the holiness of her mission. So Marina was forced to raise the child, and to make penitence for an act she never committed, she lived for a decade the life of a beggar outside the walls of the monastery.
 
Marina faced daily contempt by her peers and the local community. Yet she stood firm, never giving into the temptation to reveal the truth.
 
After she died prematurely, her gender was revealed during the purification rituals. The iniquity of the accusers was exposed posthumously, and she was venerated into Greek Orthodox sainthood.
 
The story of Hagia Marina shows us another variety of heroism. It is one thing to commit spontaneous grandiose acts of courage, risk one’s life for the sake of a grand cause, become a hero in battle, drink the hemlock for the sake of the philosophical death, become a martyr by standing tall while being maimed by lions in the Roman Coliseum. But it is much, much harder to persevere with no promise of vindication, while living the daily grind of humiliation by one’s peers. Acute pain goes away, dull pain is vastly harder to bear, and vastly more heroic.
 
Spitz
 
I have known Mark Spitznagel for long enough (more than two decades), enough to remember that he was once, briefly, a vegetarian, perhaps after reading Herman Hesse’s Sidharta in which the protagonist claims: “I can think, I can wait, I can fast”. My suggestion to follow the Greek Orthodox fast, where one is vegan two thirds of the year (and aggressively carnivore on the other third, mostly Sundays and holidays), failed to convince. Perhaps I should try again.
 
He finds ways to furtively inflict his musical tastes on his co-workers (Mahler, mainly, with performances by Von Karajan) and in the early days, as in a ritual, the conversations used to start and end with Karl Popper and central (Black Swan) asymmetries in the scientific method. There is this insistence that we are not in the business of trading, but partaking of an intellectual enterprise, that is, both applying proper inference and probability theory to the business world and, without any modesty, improving these fields according to feedback from markets. And there is all this German terminology, such as Gedankenexperiment. I suspect that there was a nonrandom geography of origin for the authors and topics that have invade the office: pre-war Vienna and its Weltanschauung.
 
Spitz has always been hardheaded; perhaps a good excuse is that it came with a remarkable clarity of mind. I must reveal that while I am far more diplomatic and less obstinate in person than I am in print, he is the exact reverse, though he hides it remarkably well to outsiders, say journalists and other suckers. He even managed to fool the author Malcolm Gladwell who covered us in the New Yorker into thinking that he would be one breaking up a fight at a bar while I would be one to initiate it.
 
The atmosphere of the office has been playfully unique. Visitors are usually confused by the sprawl of mathematical equations on the board, thinking our main edge is only mathematical. No. Both Mark and I were pit traders before doing quantitative stuff. While our work has been based on detecting mathematical flaws in existing finance models, our edge has been linked to having been in the pit and understanding the centrality of calibration, fine-tuning, execution, orderflow and transaction costs.
 
Remarkably, people who have skin in the game, that is, self-made successful people with their own money at risk (say a retired textile importer or a former shopping center developer), get it right away. On the other hand the neither-this-nor-that MBA in finance with year-end evaluation filed by the personnel department needs some helping hand –they can neither connect to the intuitions nor to the mathematics. At the time when I met Mark, we both were at the intersection of pit trading and novel branches of probability theory (such as Extreme Value Theory), an intersection that at the time (and still, presently) included no more than two persons.
 
Mutua Muli
 
Now what was the dominant idea to emerge?
 
There are activities with remote payoff and no feedback that are ignored by the common crowd.
 
With the associated corollary:
 
Never underestimate the effect of absence of feedback on the unconscious behavior and choices of people.
 
Mark kept using the example of someone playing piano for a long time with no improvement (that is, hardly capable of performing chopsticks) yet persevering; then, suddenly, one day, impeccably playing Chopin or Rachmaninoff.
 
No, it is not related to modern psychology. Psychologists discuss the notion of deferred payoff and the inability to delay one’s gratification as a hindrance. They hold that people who prefer a dollar now versus two in the future will eventually fare poorly in the course of life. But this is not at all what Spitz’s idea is about, since you do not know whether there might be a payoff at the end of the line, and, furthermore, psychologists are shoddy scientists, wrong almost all the time about almost all the things they discuss. The idea that delayed gratification confers some socio-economic advantage to those who defer was eventually debunked. The real world is a bit different. Under uncertainty, you must consider taking what you can now, since the person offering you two dollars in one year versus one today might be bankrupt then (or serving a jail sentence).
 
So what this idea is about isn’t delayed gratification, but the ability to operate without external gratification –or rather, with random gratification. Have the fortitude to live without promises.
 
Hence the second corollary:  Things that are good but don’t look good must have some edge.
 
The latter point allows she or he who is perseverant and mentally equipped to do the right thing with an endless reservoir of suckers.
 
Never underestimate people’s need to look good in the eyes of others. Scientists and artists, in order to cope with the absence of gratification, had to create such a thing as prizes and prestige journals. These are designed to satisfy the needs of the nonheroics to look good on the occasion. It does not matter if your idea is eventually proved right, there are intermediary steps in between that can be won. So “research” will be eventually gamed into some brand of nonresearch that looks cosmetically like research. You publish in a “prestige” journal and you are done, even if the full idea never materializes in the future. The game creates citation rings and clubs in fields like academic finance and economics (with no tangible feedback) where one can BS endlessly and collect accolades by peers.
 
For instance the theory of portfolio construction (or the associated “risk parity”) à la Markowitz requires correlations between assets to be both known and nonrandom. You remove these assumptions and you have no case for portfolio construction (not counting other, vastly more severe flaws, such as ergodicity, discussed in this book). Yet one must have no knowledge of the existence of computer screens and no access to data to avoid noticing that correlations are, if anything, not fixed, changing randomly. People’s only excuse for using these models is that other people are using these models.
 
And you end up with individuals who know practically nothing, but with huge resumés (a few have Nobel prizes). These citation rings or circular support groups were called mutua muli by the ancients: the association of mutually-respecting mules.
 
Cost-Effective Risk Mitigation
 
Most financial and business returns come from rare events –what happens in ordinary times is hardly relevant for the total. Financial models have done just the opposite. A fund miscalled Long Term Capital Management that blew up in 1998 was representative of such decorated mutua muli misunderstanding. The Nobel-decorated academics proved in a single month the fakeness of their models. Practically everyone in the 1980s, particularly after the crash of 1987, must have known it was quackery. However, most if not all financial analysts exhibit the clarity of mind of a New York sewer after a long weekend, which explains how the mutua muli can take hold of an entire industry.
 
Indeed the investment world is populated by analysts who, while using patently wrong mathematics, managed to look good and cosmetically sophisticated but eventually harm their clients in the long run. Why? because, simply, it is OPM (“other people’s money”) they are risking while the returns is theirs –again absence of skin in the game.
 
Steady returns (continuous ratification) comes along with hiding tail risks. Banks lost more money in two episodes, 1982 and 2008, than they made in the history of banking –but managers are still rich. They claimed that the standard models were showing low risk when they were sitting on barrels of dynamite –so we needed to destroy these models as tools of deception.
 
This risk transfer is visible in all business activities: corporations end up obeying the financial analyst dictum to avoid tail insurance: in their eyes, a company that can withstand storms can be inferior to one that is fragile to the next slight downturn or rise in interest rates, if the latter’s earning per share exceed the former’s by a fraction of a penny!
 
So the tools of modern finance helped create a “rent seeking” class of people whose interest diverged from those of their clients –and ones who get eventually bailed out by taxpayers.
 
While the financial rent seekers were clearly the enemies of society, we found actually worse enemies: the imitators.
 
For, at Universa, Spitz built a structure that tail-hedged portfolios, hence insulated him from the need for delayed random gratification. As introduced (and formulated) in Safe Haven, risk mitigation needs to be “cost-effective” (i.e., it should raise your wealth), and to do that it needs to mitigate the risks that matter, not the risks that don’t.
 
It was the birth of tail risk hedging as an investable asset class. Tail risk hedging removed the effect of the nasty Black Swan on portfolios; cost effective tail risk hedging obliterating all the other forms of risk mitigation. Accordingly, the idea grew on people and a new category was born. This led to a legion of imitators –those very same mutua muli persons who had previously been fooled by modern finance tools, finding a new thing to sell.
 
Universa proved the following: not only there is no substitute to tail risk hedging, but, when it comes to tail-risk hedging, simply –as per the boast in the Porsche advertisement — there is no substitute.
 
For when you go from a principle to execution, things are much more complicated: the output is simple to the outsider, the process is hard seen from the inside. Indeed, it takes years of study and practice, not counting natural edges and understanding of the payoffs and probabilistic mechanisms.
 
For I said earlier that Mark’s edge came from pit trading and a natural (non contrived) understanding of the mathematics of tails. Not quite. His edge has been largely behavioral and my description of hardheaded was an understatement. Perhaps the most undervalued attribute for humans is dogged, obsessive, boring, discipline: in more than two decades, I never saw him once deviate a micro-inch from a given protocol.
 
This is his monumental f*** you to the investment industry.

On April 17, Nassim Nicholas Taleb, the famous Black Swan author and provocateur, took to Twitter to call out the then-chief investment officer of the California Public Employees’ Retirement System for “B.S.” In a four-minute video recorded in a sunny room in his Atlanta home, Taleb claimed that CalPERS’ Ben Meng had “offered extremely unrigorous rebuttals about tail-risk hedging.” In its most basic form, tail-risk hedging is designed to protect investors against extremely rare events — or black swans. Taleb is an outside adviser (technically a “distinguished scientific adviser”) to Universa, but doesn’t manage any investments for the firm.
 
Two days before in a webcast, Meng had defended his now-infamous October 2019 decision to end a tail-risk hedging program, which Universa Investments anchored, shortly before it would have generated about $1 billion in gains in the March market crash. The badly timed move was immortalized in scores of headlines in the financial and local press. Taleb and Universa founder Mark Spitznagel started the first tail-risk hedge fund in 1999.
 
Meng started unraveling the initiative of his predecessor, Ted Eliopoulos, almost immediately after joining CalPERS in January 2019. He never talked to or emailed anybody at Universa about the inner workings of the strategies or his decision to abandon the hedge. He told people at the pension plan that he decided to fire Universa and another tail-risk manager because they were too costly. Meng, like many finance professionals, also never understood tail hedging, multiple sources claim. He stepped down in August and could not be reached for comment. In an emailed statement, a CalPERS spokesperson said, “The risk-mitigation strategies CalPERS put in place offset $11 billion in losses during the most volatile time period in February and March.”
 
Meng publicly attributed his decision to kill the tail hedges to their high cost, their lack of scalability, and the availability of better alternatives. He said the pension plan had other hedges in place and relied on traditional diversification.
 
Taleb countered that with an argument that is essentially the central argument of tail hedging and risk mitigation. Meng didn’t tell viewers of the webcast what the hedging strategy cost the plan in previous years. “I don’t know if you realize that these strategies need to be weighed against what they made or lost before that,” Taleb said. “Effectively, we think, back-of-the-envelope calculation, the so-called mitigating strategy would have lost something like $30 billion the previous year. So you make $11 billion, you lose $30 billion before, not a great trade. It’s definitely not a great trade over long periods of time, when you lose in rallies and make back a little bit in the selloff,” he said.
 
Taleb believes that the same flawed logic is why investors lose billions of their savings every year. They’re relying on strategies like diversification that the financial industry has long peddled to protect investors’ downside. But adding assets such as bonds, or even gold, costs investors in bull markets, without fully cushioning portfolios in a crisis.
 
Taleb says, “What Universa is doing is allowing people to stay in the game long enough to gather alpha. It’s not a luxury. It is a necessity,” he says in an interview. “How many people in the United States own a house without insurance on the house? The way they [critics of tail hedging] look at it, you won’t buy a house if the insurance is expensive. No, you would buy a smaller house. Insurance is not an option.”
 
“I’m not that emotional of a person, contrary to what it appears,” says Taleb, who is famous for social media outbursts. “But when I see some B.S., I get aggressive.”
 
Spitznagel wasn’t surprised when Meng ended CalPERS’ tail-risk hedging program. He had seen such decisions many times before. As the founder and president of Universa, he knows his products require investors to go up against modern portfolio theory and the other orthodoxy they learn in business school and starter finance jobs.
 
Pension funds’ first line of defense against crashes is diversification away from stocks into bonds and other assets. Second, they can opt for products or strategies like trend-following commodity trading advisers or gold. Ron Lagnado, who led the implementation of the tail hedge at CalPERS and is now the director of research at Universa, says, “I’ve written on the failure of diversification. With each big drawdown in the stock market, we see less and less protection coming from bonds. One of the reasons that pensions are so poorly funded is they have maintained such large allocations to bonds and other forms of risk mitigation, which are a drag on performance.”
 
Former CalPERS chief Eliopoulos, who is now at Morgan Stanley, brought in the tail hedge after hearing Taleb speak, according to sources. He did not want a repeat of CalPERS’ experience in 2008-09, when the pension was forced to sell stocks at the bottom. The pension’s funding ratio never recovered.
 
Eliopoulos and his team at CalPERS started talking to Universa in 2016, around the U.S. election. Everyone, not just CalPERS, was concerned about the risk to stocks, given the long-running bull market. The pension had already sold about $15 billion worth of shares ahead of the November election and was considering one or two more sales to reduce risk.
 
But the investment strategy group also started researching tail hedging to protect against a stock crash. By August 2017, CalPERS had implemented a pilot program, with Universa, LongTail Alpha, and some internal tail-hedge investments. The pension was the largest ever to deploy a tail hedge. The hedge was initially designed to protect about $5 billion in equities, with several planned increases that would ultimately shield about 10 percent of the stock portfolio.
 
When markets are up, a pension fund would pay a small fee to Universa and the other managers, just like insurance. But most CIOs — including Eliopoulos — aren’t in the job long enough to see a tail hedge through, and few want to defend any excess costs to their boards.
 
Lagnado gets upset thinking about Meng’s defense of conventional diversification as less costly than Universa’s options-based risk mitigation.
 
In an internal Universa document that ended up getting leaked to the press in April, Lagnado argued that CalPERS was essentially using a conventional 60-40 portfolio for risk mitigation, with 60 percent of the assets invested in the S&P 500 and 40 percent invested in the Barclays U.S. Aggregate Bond Index. Universa calculated that over the 12-year period, the compound annual growth rate trailed an all-stock portfolio by 1 percent per year and 11.3 percent cumulatively. That’s not risk mitigation, he explained.
 
From his home in northern Michigan, Spitznagel says the misunderstanding about tail hedging — a name he says he has come to hate because it’s been co-opted by marketers — comes down to simple concepts.
 
Tail-risk hedging, or risk mitigation, as Spitznagel prefers to call it, should raise an investor’s wealth. “That seems obvious. You would think the name of the game is to raise wealth,” he says. I first met Spitznagel and Brandon Yarckin, Universa’s chief operating officer, at the Plaza Hotel in Manhattan in January, before Covid-19 shut down the city. On the phone, Spitznagel starts talking faster and louder as he rattles off his points about conventional wisdom in the industry.
 
Modern finance offers up strategies like diversification, which lowers people’s wealth, he says. “And it does that very, very well. That’s a definitive statement. Even the most successful proponents of diversification, like Ray Dalio, openly say that it lowers your returns. But the argument is that it smooths your ride, even if it makes you poorer at the end of the day.” A portfolio made up of many different types of investments will weather different markets. One investment — say, real estate — will do well, even as another asset declines in value.
 
But it’s the big losses that matter when it comes to compounding. “That’s not my opinion; it’s not even an empirical observation. This is a mathematical fact,” Spitznagel says. “That is tail hedging. People don’t understand any of that. It flies in the face of everything we’ve been taught.”
 
A former hedge fund manager who declined to be named agrees with Universa’s founder. “Yep, the entire hedge fund industry is predicated on lowering the volatility of investors’ portfolios. No one will say this out loud, but what’s the point of that? It lowers the psychological pain during a crash, but it doesn’t maximize wealth. It’s a crude solution.” The hedge fund manager says all risk-mitigation strategies rely on some kind of diversification, negative risk correlations, or market timing.
 
Spitznagel gets wound up and almost shouts into the phone when talking about hedge funds. “Risk mitigation should raise your returns. But no one will come up with that.”
 
Spitznagel won’t talk about performance because of compliance reasons, but he says Universa has proved itself through two crises and multiple mini-downturns since 2007. Although Universa generated a 4,144 percent return in the first quarter of 2020, it’s the overall portfolio effect that matters more, according to a client letter obtained by II. The portfolio effect is the impact it has on the compound annual growth rate (CAGR) of an investor’s entire portfolio.
 
In March 2020, a hypothetical portfolio with 3.33 percent in the Universa tail-risk strategy and 96.67 percent in the Standard & Poor’s 500 stock index had a CAGR of 0.4 percent. The S&P 500 is a proxy the firm uses for the systematic risk the investor is mitigating.
 
The S&P 500 had declined 12.4 percent as of the end of March. Since the end of 2019, Universa’s hypothetical portfolio has returned 16.2 percent, compared with the S&P’s 4.5 percent. Most telling, the portfolio has gained 11.5 percent per year since inception in March 2008. The S&P has returned 7.9 percent per year over the same period. According to an audited performance statement from a source close to the firm, Universa’s life-to-date average annual return on invested capital across all Black Swan Protection Protocol funds from January 1, 2008, to December 31, 2019, was 105.2 percent.
 
But tail-hedging products remain devilishly difficult to sell.
 
Karyn Williams, founder of consultant Hightree Advisors and former CIO of Farmers Insurance, says, “What do people see with a tail hedge? They see a line item, and that line item looks like a drag on performance for most of its productive life. You don’t always see a return, but you do see this cost associated with it. If you’re the CIO, you want more returns, not less.”
 
Williams adds that some tail-hedge managers have even changed their underlying processes to reduce this cost or even show returns in up markets. “It’s because of the pressure of being a line item that sticks out every quarter like sore thumb.”

Spitznagel believes he was brainwashed.
 
That’s how he describes his experience with his mentor, Everett Klipp, as a teenager in the Chicago trading pits. Spitznagel’s father brought him down to the floor in the 1980s to meet Klipp, a family friend. “I was mesmerized. I was 16 and I wanted to be a pit trader. I wanted to be specifically in the corn pit.”
 
As a clerk, Spitznagel would bring U.S. Department of Agriculture crop reports to Klipp. He’d tell Spitznagel that nothing he could read would tell him what the price of corn would be. You can’t forecast. “All that matters is you have to be able to take a lot of small losses,” Klipp told Spitznagel. “He was brainwashing me that you have to be positively skewed,” he laughs.
 
Getting serious, Spitznagel contrasts that with people coming out of Harvard Business School, who graduate and join Goldman Sachs’s proprietary trading desk. “They’re taught the reverse. That a good trade is one that prints a small amount of money all the time. That’s a good strategy until you lose it all and then some. I was taught the opposite. You have to look like an ass and feel like an ass to be a good trader.”
 
After Spitznagel graduated, Klipp backed him and he became the youngest trader in the U.S. Treasury bond pit at 21. He then went on to become a prop trader at Nippon Credit Bank.
 
In 1999, he took a sabbatical and went to New York University’s Courant Institute of Mathematical Sciences, where he met Taleb. They decided to start Empirica Capital, the first formal tail-hedging fund. Spitznagel was the trader and Taleb raised the assets. Four years later, Taleb faced health issues, and the two shut the firm down. Spitznagel briefly joined Morgan Stanley’s proprietary process-driven trading group, PDT Partners, before starting Universa in 2007.
 
COO Yarckin was a derivatives broker at D.E. Shaw subsidiary KBC Financial Products, which covered Empirica, and helped Spitznagel start Universa. Selling hedges, he says, has always been an uphill battle. Investors may say they want protection, but they don’t want to stray too far from what they can easily explain to their boards. “If you’re providing masks during a pandemic, it’s probably very easy. However, think of us as having to explain why you’d need a mask in the first place,” Yarckin says.
 
The structure of the financial industry, including incentives and the “agent” problem, also weighs on tail hedging. CIOs are rewarded based on beating benchmarks, not averting disaster. Plus, it’s not their money; they’re only the agent. That’s why the majority of Universa’s investors are family offices and high-net-worth individuals, he believes. These people feel the pain personally when crisis strikes.
 
The pain at a pension fund is indirect, hitting beneficiaries, and perhaps taxpayers, who need to make up any shortfalls.
 
Taleb likewise believes he’s spent his life not being understood. “But it doesn’t matter much. It forces you to be robust in your arguments. When you’re robust, you don’t really care,” he says.
 
“What I’m saying is not controversial for the people who practice decision-making; it’s only controversial for analysts or people who get paid but don’t have skin in the game,” says Taleb.
 
“Betting on doom” is popular shorthand for tail hedging — yet another piece of industry lingo Spitznagel dislikes. It’s misleading; he doesn’t need a stock market crash to prove the strategy’s effectiveness.
 
Clients tend to devote only a fraction of their portfolio to the hedging product. This means they can allocate more to stocks — getting more systematic exposure — because their risk is hedged. “Maybe that’s part of the problem,” Spitznagel says. “You’ve got to believe that something really bad is happening. We’ll get an asteroid strike or something. It’s a bet on doom. But nothing is further from the truth.”
 
Universa’s strategy should be the next risk parity, he believes. “But we never will be. We should be the dominant new paradigm in risk mitigation.” The risk-parity comment is barely out of Spitznagel’s mouth before he says, “Universa’s success comes because people don’t believe it works. If they did, we wouldn’t have a business.”
 
CalPERS — Universa’s most infamous doubter — will forever be part of the company’s story, Lagnado believes.
 
The pension fund’s decision comes down to behavioral mistakes, says Spitznagel. There’s an explicit annual “insurance cost” to tail hedging, just as any other risk-mitigation measure has a price. For example, CalPERS lost out on four years of gains after the fund sold about $15 billion in equities in 2016.
 
But that number wasn’t written down in a balance sheet.

What stands out dramatically is that the compound annual growth rate (CAGR) for bonds over the full period including the GFC is virtually the same as for the recovery period. With equities rallying during the recovery, the allocation to bonds created a 4.8 percent drag, reducing the CAGR of 16.3 percent for a full investment in equities to 11.5 percent for the 60/40 portfolio.
Even over the full period spanning the GFC, the large allocation to bonds still failed to provide enough protection to add value over the cycle — reducing the CAGR by 170 basis points. Astonishingly, this occurred in spite of concurrent bull-market rallies in bonds and equities during the recovery. Pension funds adopting the standard diversified portfolio failed to achieve a sufficient rate of return to improve funded status meaningfully.  
 
There are valid reasons to hold some allocation to bonds. Maintenance of liquidity is one. However, investors must seriously consider the limited diversification and risk mitigation benefits — and explore other avenues. Direct tail-risk hedging using equity put options has proven a successful approach. Tail-risk hedging provides protection against extreme market moves that have occurred historically at a frequency well beyond what is predicted by a normal return distribution.
 
Properly managed options-based tail-risk hedging can raise the CAGR where bonds have failed. Over time this can improve funded ratios, regardless of interim market crashes. Standard risk mitigation through diversification in the pursuit of higher Sharpe ratio has almost uniformly lowered the CAGR of a typical pension over a full market cycle.
 
To be clear, there is no free lunch, as the ideal options strategies trade small losses over extended periods when equities are rising for extremely large gains during the less frequent but devastating drawdowns. However, when executed correctly, and in the appropriate size relative to the overall portfolio, the long-term benefits in terms of CAGR can be substantial, as investors can maintain a greater allocation to equities due to the risk reduction from direct hedging. 
 
At present, return targets for state pension funds are 7 percent or greater. Looking to the future, it is unclear how pension funds with a required return of 7 percent will be able to maintain or improve funded status with standard diversification. Today’s exceptionally low bond yields do not bode well for achieving such return targets with a typical allocation to fixed income. To make matters worse, such balanced portfolios are likely to provide less protection than in 2008 during a future crisis of similar magnitude. The next financial crisis with a 30 percent or greater decline in equities may deliver a fatal blow.
 
Recent experience and longer history shows that the assumed negative correlation between bonds and equities is not as reliable as we would hope for. That means state pension funds are unlikely to achieve the 7 percent return necessary to stay afloat if they continue to blindly follow the standard diversification strategy. Rather, pension funds should explore alternative approaches to ensure that the money is there when teachers and firefighters and other essential workers choose to retire.
 
Until then, diversification for its own sake is not a strategy for success.