As the wrap-up of this portfolio design series, a exploration of the tools and concepts in Pursuing the Perfect Portfolio Design is in order. In part one, the advantages of low cost investment vehicles and broad diversification were explored. The evidence is clear that the proliferation of available data globally has brought an amazing amount of efficiency to traditional stock and bond investment markets. It is difficult exploit this information to gain an advantage. In part two, the notion of additional tools in the investment toolbox to reduce volatility of a portfolio and increase its effectiveness to meet individual goals is introduced.
Some investors might think of diversification as holding more than one security. While true, a more effective approach on the path to lower volatility is to consider multiple asset classes exhibiting different qualities to each other. This is known as correlation. I prefer to refer to think of correlation simply as the relationship to the movement of another asset. Perfect correlation is a correlation of ‘1’, or moving exactly like the asset being compared as time moves on. Negative correlation is commonly referred to as ‘-1’, and one would expect that when one asset goes up, the one being compared is moving down.
Of course, if all assets were ‘+1’ or ‘-1’, comparing would be quite simple. Our world is never quite that black and white, unfortunately. Most assets correlations are somewhere between +1 and -1. Where should we draw the line to ascertain if an asset is going to add value? In my opinion, assets with a .7 correlation or higher add little in the way of true effectiveness in diversification. Negative correlations of less than ‘0’ would be ideal, but there are only a few to choose from. A resource available to all is BNY Mellon 10 Year Capital Market Assumptions. While we would never put blind faith in anyone’s assumptions, including our own, there is a wealth of usable data starting on page 14. There are the 10 year correlations of multiple asset classes, with negative correlations highlighted.
A good exercise is to look at the holdings in your portfolio and determine how each of the asset classes is correlated with the other holdings. As mentioned above, if the holdings are correlated by .7 or higher, then there is opportunity for better diversification and portfolio effectiveness by putting a design with higher effectiveness in place. A skilled professional can make the job much easier, but the data is available for your use.
The illustration in part two of this series used an allocation to alternatives of approximately 30% of the portfolio to bring about the results shown. Of course, allocations can be adjusted to fit an investor’s comfort level. Individual selection of investments also requires greater attention and diligence to selection of individual investments. Two resources that may be helpful would be my latest book: “The Other Path: Illuminating the Path toward Reduced Volatility while Achieving Equity-Type Returns, and a previous post entitled “Alternative Investments: 7 Principles for Selection”. Don’t hesitate to reach out with questions or comments.