As part of what one of our managers described as “a bull market in fear,” 2012 was a year in which central banks around the world ganged up against savers and forced them to choose between monetary debasement and navigating a minefield trying to escape it.

We believe many of the uncertainties that clouded the horizon in 2012 are slowly being resolved or constructively contained. In fact, we also see domestic economic strength that would indicate an earlier hike in interest rates than is currently priced into the market.

Investors can often mistake the asset diversity in their portfolios for adequate risk diversification. Author Jason Hsu, of Research Affiliates, argues many investors who are diversified around investment products may be poorly diversified by risks.

It’s been said physics explains 99% of the world with three laws, while economics explains 3% of the world with 99 laws. We found the data in the table interesting for a number of reasons, but namely for the fact that it would be nearly impossible for a trained economist to make sense of the past five or so years given these snapshots in time.

The professional investor who is benchmark agnostic, who doesn’t seek to eke out every penny of return at the expense of risk, who focuses on downside protection, and who is not handcuffed by a certain business model – be it active, passive or otherwise – has better odds of controlling for volatility.

Of all the experts that we would expect to undermine the basis of passive (index) investing, Standard and Poor’s, the creator of the widely-followed S&P 500 Index, was not high on our list. However, in a recent piece The Low-Volatility Effect: A Comprehensive Look, the company inadvertently does just that.

Indexing has always been peddled as a cheap, tax-efficient and safe way to get market returns. While it is unquestionably the cheapest and among the most tax-efficient ways to invest, safe it is not, the research shows.

Because of their formulaic nature, many indexes are prone to distortions over time (as we saw in the late 90’s, valuations on tech stocks drove up their market capitalizations and caused the tech weighting of the Russell 1000 Growth Index to hit 50% by 2000. Again in 2007, high flying financials rose to 36% of the Russell 1000 Value Index the year before delivering crushing losses).

We seem to live in a world where the markets believe bad news is good news. The worse things get, the more excited markets become about yet another round of stimulus by the Federal Reserve. Whether it’s uncertainty around Greek elections or weak economic data, markets have supreme confidence in the willingness of the Fed to support financial markets during economic weakness.

During market turmoil, traditional portfolios often decline more than investors expect, due to different, seemingly unrelated, asset classes moving in unison. As Ben Levisohn and Joe Light of the Wall Street Journal write, traditional asset allocation fails to achieve stable and robust diversification.

Today, the Fed has engineered a situation in which the really unattractive asset classes are the ones we have always thought of as low risk: government bonds and cash. And unlike the internet and housing bubbles, this time it isn’t a quasi-inadvertent side effect of Fed policies, but a basic aim of them.

Our goal is to grow your wealth with the most robust and stable diversification possible. Risk limits, stress testing and so on may be very useful tools, but can’t overcome fundamentally flawed portfolio construction any more than a seatbelt can solve the problems inherent in reckless driving.

Overall, we’re cautiously optimistic about the recovery domestically, with an eye toward the various external macro forces that could disrupt it. As you know, we believe true diversification is a proactive process that requires looking under the surface of stated asset class objectives to identify underlying performance drivers and risks that could pervade multiple asset classes.

In financial markets, equilibrium is a constantly moving target; the textbook “steady state” or “balance” doesn’t exist in an open and global economy. Some external shock is introduced and markets adjust to find the new balance between supply and demand for different assets.

The renewed strength that the US economy began to show late last year has translated into a number of opportunities in credit and equities domestically. On the credit side, our managers are tilting away from richer high yield and treasury bonds in favor of mortgage-backed securities and high quality corporate bonds.

It is not enough to take a narrow look at “Greece” or “Europe” exposure without exploring the various risk factors and knock-on effects associated with it – it’s impact on liquidity, volatility, growth and so on. One of the more likely secondary effects the European crisis will be on certain emerging markets investments.

At Rain, we decompose strategies by risk factors. We deliberately select strategies on the defensive end of portfolios that are diversified by those risk factors. We use tools on the bond side that allow for far greater flexibility to manage exposure to interest rate and credit spread risk as well as non-fixed-income-centric strategies whose returns are largely independent of interest rate risk and safe-haven volatility. This allows us to build more dependable and truly diversified qualities into the defensive side of client portfolios.

There is always a trade-off between the return sacrifice and diversification benefit a strategy brings to a portfolio. Long-dated bonds and treasuries in particular, have demonstrated strong diversification benefits in portfolio construction because of their negative correlation to other asset classes, like equities.

Widely accepted ways of measuring risk simply do a poor job of showing it. Risk encompasses the multitude of scenarios an investment could deliver, not the single path that ends up being measured afterward. In other words, volatility, standard deviation (and the many ways they are sliced and diced in risk management models) tells us what has happened, not what might have happened or could happen in the future.

Bonds are the parachutes of the investment world; they have offered safe, stable income and their prices generally go up when everything else goes down, giving them a nice defensive quality in portfolios. Falling interest rates are the wind that keeps the parachute open and the greater the duration (interest rate sensitivity), the softer the landing.

Bonds are exposed to interest rate risk and the greater a bond’s duration, the greater the sensitivity to that risk. Perhaps more importantly given the current interest rate environment, the more rates fall, the more that risk rises exponentially.

Asset allocation was intended to be a means by which to diversify, not an end in itself. Despite ample examples of how insufficiently asset allocation diversifies risk – the Fall of 1998, the dot-com crash of 2000, the high yield debt rout of 2003, the credit crisis of 2008, and so on – the industry overwhelmingly continues to use it as the primary means by which to build portfolios.

At Rain, we start with the premise that risk considerations should drive capital allocation, rather than letting capital allocation drive portfolio risk. This means that the building blocks of our portfolio construction are the direct risk factors that drive asset valuation like inflation, economic growth, interest rates, liquidity, volatility, and so on.

The relationships that made asset allocation an effective way to diversify have changed. Correlations between most asset classes have been creeping steadily upward since the mid-1990s.

Investors have been told investing across different asset classes (known in the industry as asset allocation) is the best means of diversifying their portfolio, yet they continue to experience violent swings in the value of their wealth with each successive crisis.

Humankind innovates faster than we can solve the problems our innovations create. Wall Street is a case in point. What started with simple barter between individuals who produced goods each other wanted, evolved into trading shells, beads, commodities, coins, trade bills and so on ad nauseum.