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Advisors’ portfolio construction “needs to evolve” and adjustments must be made regularly to meet investors’ aspirations, according to James Peterson, senior vice president of Charles Schwab Investment Advisory.

To accomplish that, advisors must make sure they are addressing four key areas, said Peterson, who spoke at last week’s Schwab Impact conference in San Diego.

First, advisors must think about expected returns and the fact they’re lower than actual returns, he said in a session called “Revisiting Modern Portfolio Theory: Does Global Diversification Still Work?”

Second, advisors must make sure to factor in “bouts of volatility” through better risk-measurement techniques, he said.

Third, advisors need to address the “changing correlations” of different assets in a portfolio over time based on market conditions, he noted.

And fourth, “pay attention to risk allocations” via “thoughtful portfolio construction and asset class selection,” Peterson cautioned.

He also warned that, as the investing world has become more globalized, investors really should be expanding their investment horizons by diversifying portfolios to include opportunities outside the U.S.

After all, said Peterson, there is a significant “world of investment opportunities” in other countries. Citing 2018 World Bank data, he pointed out that U.S. stocks accounted for just 44% of world market capitalization; international developed stocks, 24%; and emerging market stocks, 23%.

International stocks also have higher long-term expected returns – partly due to better valuations  – and lower price/earnings ratios, Peterson noted. Successful investors focus on expected future performance, not what has happened in the recent past.

To answer the question posed by the title of the Schwab session: Yes, global diversification still works, and a diversified portfolio in general still helps reduce risk over time, according to Peterson.

“Asset allocation arguably is the most important thing we do as investors. Certainly, as advisors working with clients, how to allocate their assets is obviously really important as well,” Peterson told attendees at the start of the presentation.

“Despite the fact that asset allocation is something that has been around for a long time and modern portfolio theory is the way we kind of determine what the asset allocation is,” there haven’t been many “big advancements” during the first 50 years or so of portfolio construction research, he pointed out.

“But that’s changed” due to the “credit crisis,” said Peterson. “People started questioning the concept of diversification” because it’s “much easier to do portfolio optimization and the mathematics of portfolio construction today than it ever used to be,” he said.