Thursday, October 04, 2007

Advanced Portfolio Building

Warning: the information in this post is about how to achieve more effective diversification in your portfolio. It may actually be useful, but it might not be an easy read.

Diversification is a very useful trick. It allows you to maximize your return for a given level of risk, or to minimize your exposure to risk at any target level of return. Diversification works because different assets do not always move in lock-step, such that a decline in the price of one asset is often offset by an increase in the price of another asset.

Diversification becomes more effective as the correlation between your different asset classes declines. In other words, if you want to increase your level of diversification, your portfolio needs to include asset classes that have a more tenuous link with each other, or better yet, assets that are negatively correlated. For those readers who are less statistically inclined, if two assets are negatively correlated they tend to move in opposite directions.

Although our portfolio is well diversified by most measures, I noticed that during much of the market turmoil we experienced in July, most of our asset classes moved in the same direction: down. Domestic and international stocks, bonds and real estate all seemed to face the same price pressures. This prompted me to do some research, and led me to discover this phenomenal article, in the July issue of the Journal of Financial Planning. The article offers detailed correlation matrices between 17 different asset classes.

According to the article, the asset classes that exhibit the lowest average correlation with the S&P 500 are: U.S. Bonds (0.23); Global Bonds (-0.03); Cash (0.02); Natural Resources (0.01); and Long - Short investments (-0.01). Let me interpret these results for you: on average, if the S&P moves up by 1% on a given day, the average cash position will tend to move 0.02% in the same direction, while a diversified global bond position would tend to move 0.03% in the opposite direction.

Bonds truly are an excellent way to diversify a stock position. Global bonds are an even better way to achieve this goal. How many of us have global bonds in our portfolio? Not very many.

How do real estate (as measured by REITs) and International stocks fare in the diversification department? Good, but not great. International stocks have an average correlation of 0.55 with the S&P, while REITs have an average correlation of 0.52. In addition, at certain times these asset classes exhibit a substantially higher correlation with the U.S. equity market. So, while these asset classes offer substantial diversification, this benefit sometimes diminishes to a large extent.

Without boring you with the details of the statistical analysis offered in the article, you should note that the correlation values provided above are averages and that the correlations of some asset classes vary dramatically over the years. However, the article mentions natural resources, long-short, U.S. bonds, global bonds and cash as the five asset classes that consistently offer the best diversification benefits with an equity position. It is also interesting to note that the same asset classes also have a weak correlation with each other.

I highly recommend taking the time to read the full article for yourself.

More about this article and its take aways in the coming days.


Matthew said...

There are two methods for reducing volatility in a portfolio: building a basket of assets with weakly or anti-correlated betas, or increasing your time horizon. No discussion of risk and reward is complete without including the impact of time on both quantities.

Given a sufficiently long window, there is no reason to invest in anything but 100% equities. Diversifying beyond this asset class would only create a drag on your final return and increase transaction costs.

Matthew @ Crazy Money

Pinyo said...

This article is an excellent write up on asset allocation and diversification. I am thinking about adding bonds to my portfolio and this article really helped.