Global markets are transitioning to a new set of norms in the aftermath of the financial crisis, and the new norms will fundamentally change investing and the concept of asset allocation, an investment industry author and executive said on Friday.

Mohamed El-Erian, CEO and co-chief investment officer of global fixed income manager Pacific Investment Management Co. and author of the book When Markets Collide: Investment Strategies for the Age of Global Economic Change, spoke to members of the Toronto CFA Society on Friday. He said the financial crisis represented a shock to the core of the global financial system, and warned that the system will operate in a drastically different way in the future.

“Global markets and the global economic system will not reset to where we were before financial crisis occurred,” El-Erian said.

He said the global economy would ultimately have lower growth potential, and the financial system will face higher levels of regulation. Economic fundamentals are set to be especially different in the United States, he said, which will see higher unemployment rates and higher savings rates in the long run.

“The new normal is a world in which the growth potential of the United States, and therefore the growth potential of the rest of the world, is lower,” El-Erian said.

The new norms will also be “fundamentally consequential” for investors, he added. In particular, he said the concept of asset allocation will change. Rather than designing a portfolio around different asset classes, investors will build portfolios based on risk classes, classifying their investments in terms of their exposure to equity risk, default risk, inflation risk, public policy risk and other types of risk.

El-Erian expects investors to more carefully analyze investment vehicles based on the compensation they provide for the risk they involve. Portfolio diversification will remain an important method of mitigating risk, but will no longer be sufficient, he added.

“It is not a sufficient risk mitigation tool,” he said, explaining that much more extensive risk-management efforts will be necessary for investors.

Financial services firms are also set to face a new operating environment, El-Erian said. As regulations increase, he expects the cost of doing business to rise. In addition, he said higher barriers to entry are likely to result from the reduced level of public trust in the financial sector.

“Trust has been significantly affected in the last year, so the barrier to entry is going to be higher,” said El-Erian. “Trust is going to have to be earned.”

As a result of these factors, he expects to see greater industry consolidation.

Financial markets have not yet come to terms with the vast changes that lie ahead, according to El-Erian. Based on the recent rallies in stock markets, he said investors are apparently assuming that the economic recovery will follow the pattern of historic ones, and are expecting growth to return to previous levels in a cyclical nature.

But El-Erian pointed out that much of the recovery so far has been driven by fiscal stimulus rather than the return of consumer demand. Valuations in the market, he said, are too optimistic about the recovery underway.

He expects markets to eventually realize the lack of fundamental strength in the recovery, which could cause a market correction.

IE