Considering all of these relationships (in parts 1 through 4), it seems that the fully diversified allocation of investments would (assuming a 60% equity share of assets) start with a 60% equity position (which is really a 100% long position in corporate assets, and a 40% short position in corporate bonds) and pair that with a long 40% bond position. This gives a net position that is 100% long on productive assets, by being allocated 60% equities and 40% bonds, for a total allocation of 100%.
In this new asset allocation system, when firms leverage up so that equity becomes 50% of total assets, investors should decrease their equity share to 50%. This would provide a level risk-adjusted exposure to productive assets. If firms are adjusting leverage over time because of interest rate levels, then this will pull the portfolio into bonds when bonds are earning more, and it will adjust for the financial leverage embedded in the market equity portfolio as it changes over time.
To the extent that leverage changes as a result of cyclical shocks to equity value, this method of allocation would not necessarily be optimal, because it would not call for significant rebalancing into equities during sharp market downturns. Equities would naturally reflect higher leverage during these times, and so this portfolio allocation system would lower the target equity allocation as the market value of equities declined.
The advantages of contrarian investing and naïve rebalancing are well known. So, to the extent that this form of allocation avoided contrarian rebalancing, it would probably hurt cumulative returns. To some extent, the normal, naïve method of rebalancing is a sort of white lie of omission that we allow ourselves to ignore. By pretending that equities in a downturn represent the same security that they did in pricey markets, we can trick ourselves into ignoring our risk averse nature in order to buy more equities when they are more risky.
On the other hand, a manager of a sophisticated portfolio might use this model to clarify the fundamentals of a volatile market. It is probably almost always a good idea to take the contrarian position in equities, and to push them back to, say, 60% of your portfolio when the market has pushed their values down to only 50%. But, it might be wise and useful to understand this position as a tactical one. Naïve rebalancing appears to be a passive investment strategy, but is instead a contrarian speculative strategy.
On the other hand, if there is systematic herding behavior in markets that is sub-optimal with regard to cumulative returns (and there certainly is, for perfectly defensible reasons), then an EMH-based measure of passivity may be missing systematic mis-pricing, and the systematic (seemingly) tactical re-weighting of equities against this tendency might actually be the passive technique. And, maybe, naïve rebalancing is a way to outsmart the market tactically without letting our monkey mind get in the way.
On the other hand...iocane comes from Australia, as everyone knows, and Australia is entirely peopled with criminals, and criminals are used to having people not trust them, as you are not trusted by me, so I can clearly not choose the wine in front of you....and, of course, all of this analysis is suspect, as long as we continue to be involved in land wars in Asia.