Hi everyone
I'm actually 100% stocks and I'm fine with it. But everywhere I read about investing, they counsel people that want a smoother ride, less up/downs etc, to reduce volatility by diversifiying and using not-so-correlated asset classes, like bond.
But why I never find any indication about short-index ETF? Aren't this the only true perfectly uncorrelated product?
The investor in broad index believe that the market always goes up, let's say at about 8% annually.
So if my portfolio looks like this:
75% long S&P500 ETF
25% short S&P500 ETF
I'll have following expected return: 75% x 8% - 25% x 8% = 4%
with a far smoother ride that bond and with a certainty of 100% that for every crash my short ETF will go up.
Hell, you could even use a 60% long - 40% short index allocation as "Saving accounts/emergency fund" with an expected average return of 1.6%.
What do I understand wrong? These short ETF are truly the inverse, right? So I don't see any problem.
Thanks to all you gurus for the enlightment :)
I'll try to keep this light, as we all don't have a statistics background.
Positive correlation (+1) means two stocks (or any two securities) move in perfect sync, in the same direction. For every $1 A goes up, B also goes up $1.
Negative correlation (-1) means two stocks (or any two securities) move in perfect sync, in the opposite direction. For every $1 A goes up, B goes down $1.
Buying an inverse ETF has a -1 correlation to a long ETF (not perfect -1, but pretty darn close).
The purpose of diversification is to purchase assets which are
uncorrelated (0). That is, the movement in A is unrelated to the movement in B. Most likely it's between -0.3 and +0.3, as few assets have a correlation of 0, but you get the idea. For every $1 A goes up, there is no statistically significant movement in B (i.e. if you drew a scatter plot of the returns, it would appear to be all over the place and you couldn't draw a line and get very close to both).
A common example of an uncorrelated asset to stocks is real estate, as it has its own booms/busts and other issues and doesn't follow the stock pattern very closely over a long period of time.