I recently finished reading Beyond diversification from Sebastien Page. Sebastien Page (Chief Investment Officer at T. Rowe Price) explains in Beyond diversification the different approaches to forecasting returns, risks and correlations across asset classes by combining academic research and practical hands-on examples.
This book is most likely targeted at the sophisticated investor and should not be the first book to pick up if you want to understand diversification but it provides great insights on how asset managers think about their portfolios.
The book also extensively refers to a number of academic papers that Sebastien Page has written on asset allocation, risk measurement and return forecasting. It explores a number of dynamic asset allocation strategies, acknowledging that risk is time-varying and requires adaptive approaches. Sebastien Page also explains why the typical fixed weight asset allocation (60-40 portfolio) does not deliver a constant risk exposure.
The book recommends using a heuristics to cope with changes in volatility: assume that next month's volatility for each asset class will be the same as last month's. For the longer term the opposite is true, 5 years of calm markets are more likely to be followed by 5 years of turbulence.
The stock-bond mix is the biggest decision that multi-asset investeros make, but this mix does not reliably reduce risk as correlations shift. Stock bond correlations were positive in the 1970s and 1980s when inflation and interest rates drove volality but then the correlation reversed.
PS With volatility being a proxy for risk, you might also check out the white paper "Practical Issues in Forecasting volatility" from Clive Granger and Ser Huang Poon which was published in the Financial Analyst Journal in February 2005.
