Investing may not have an obvious finale, but there's always a beginning. The question of how to begin doesn't receive the attention it deserves, but no one should confuse popularity with relevance in finance.

Portfolio design should start with an objective review of the risk and return possibilities, even though the crowd thinks otherwise. Just as a football coach or corporate manager must weigh the strengths and weakness of his team before making critical decisions, strategic portfolio analysis should commence with an impartial look at the implied payoffs for risk among the major asset classes.

Surveying the future with absolute objectivity and clarity isn't possible, of course, but we should still make an effort to assess the markets with as little bias as possible. To the degree we succeed, we have a useful frame of reference for adjusting the portfolio mix to satisfy each client's objectives, risk tolerance, etc. Developing a neutral outlook also provides some context for any short-term forecasts we care to make.

What's a neutral outlook? One answer comes from equilibrium-based estimates of risk premiums. These are assumptions about future prices in a world where supply matches demand. Supply and demand are constantly in flux, but the process of making long-term equilibrium forecasts is helpful for judging how our assumptions about risk translate into asset allocation decisions.

The rationale for making equilibrium projections comes from modern portfolio theory. Citing MPT may sound naive in the wake of 2008's financial cataclysm, but the recent attacks on finance theory are misguided. For example, some critics dismiss MPT by claiming that it demands a mindless acceptance of buy-and-hold asset allocation based on extrapolating historical returns into the future. MPT says nothing of the kind. In fact, the founding document in MPT-Harry Markowitz's 1952 "Portfolio Selection" paper-states clearly that some degree of looking ahead and estimating risk and return is vital.

The past isn't irrelevant, but neither should it be used as a shortcut for the hard work of designing and managing asset allocation through time. The solution is blending current and historical market information with expectations. That's no silver bullet, of course. MPT's output is directly related to the skills of the person wielding it-garbage in, garbage out, as they say. But at least we know where to begin.

MPT tells us that the market portfolio is optimal for the average investor for the infinite future. Over the long haul, an unmanaged, passive asset allocation of the major asset classes is likely to generate middling returns and risk relative to a wide spectrum of active portfolio strategies and individual asset classes. That leads us to the fundamental investment challenge: deciding how to customize Mr. Market's passive asset allocation.

Why customize? The short answer is that no one is average and everyone has a finite time horizon. But before we start second-guessing the market portfolio, we need something approaching an impartial yardstick for projecting the long-run outlook for major asset classes. In short, we must calculate equilibrium risk premiums.

With robust estimates in hand, we can begin analyzing the markets and customizing the asset allocation. To the extent that our intermediate outlook differs from predictions of long-term equilibrium risk premiums, we have a reference point for adjusting asset allocation. What if you don't have a strongly held view at the moment for equities? The fence-sitting implies holding the passive market-cap weights for asset classes until more convincing evidence sways your view.

Robert Litterman, chairman of the Quantitative Investment Strategies Group at Goldman Sachs Asset Management, summarizes the reasoning in Modern Investment Management: An Equilibrium Approach (Wiley, 2003). "We need not assume that markets are always in equilibrium to find an equilibrium approach useful," Litterman writes. "Rather, we view the world as a complex, highly random system in which there is a constant barrage of new data and shocks to existing valuations that as often as not knock the system away from equilibrium."

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