Author Topic: What am I to make of this?  (Read 1977 times)

FrugalFisherman10

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What am I to make of this?
« on: December 07, 2016, 07:41:56 AM »
I just read an interesting blurb that kinda blew up my brain on asset allocation stuff. Here’s the gist (this is long):
 
People usually consider diversification across asset classes as a good way to minimize risk (of a drawdown for example.) Why? Because certain asset classes move in opposite directions, and have a ‘correlation’ in the way they do so.
Example (with fake numbers):
Say Large Cap stocks go up during the period 1980 – 1990 a total of 20%, and REITS go down a total of 10%. So the REITs create a drag on the portfolio, to the extent you held them. Additionally, say the REIT to Large Cap Stock correlation during that period was .5. (I.e. you can know that whatever your stocks do, REITs will do the opposite, to some extent… To the extent that they are correlated, which in this fake example is -.5 for the period 1980 - 1990.)
Then in 1990 – 2000, Stocks go down 20%, and REITS go UP 10%. So the REITS minimize your portfolio’s drawdown, to the extent you held them. (again, you can know that whatever your stocks did, REITs will do the opposite, to some extent… To the extent that they are correlated, which in this fake example so far is -.5 for the period 1990 – 2000)
Then, what if the correlation changes? Boom.
Say from 2000 to 2009, Stocks go up by 10%, and REITS go up by 15%. Call this correlation +.35. Why would that happen?  All kinds of complex actual factors in the economy. Say the companies that are Large Cap Stocks all each have heavy ties in their business model to the performance of their real estate. Or companies like construction and lumber become the Large Cap Stock companies of the world.
Now, your Large Cap Stocks are super tied and ‘moving in the same direction’ as your REITS. (Direction also has something to do with beta or alpha from the Finance 3000 days, can’t remember which).
REITS can no longer be used in your portfolio to combat the volatility of Large Cap Stocks, instead, they add to it. They multiply it. Because the world and the market factors and how stuff works has fundamentally changed. (lending practices, would be an example).
 
You were going to use the REITS to help you during downtimes of Large Cap Stocks, and in the meantime the world changed and they are doing the opposite for you.
 
Sounds scary, (if it doesn’t, re-read the paragraph before this with negative numbers) but this doesn’t really happen does it? Actually, apparently it does, and this is fairly overlooked (at least by me). These papers did studies on changing correlations over decades at a time.
 
Excerpts: The Volatility of Correlation: Important Implications for the Asset Allocation Decision by William J. Coaker II,* The average variance in correlation measured 0.98 over one year and 0.25 over ten years. In short, the relationship among many of the asset classes appears to be inherently unstable.
* Correlations exhibit uniqueness, meaning periods are distinct from previous time periods. For example, international stocks' correlation to the S&P 500 was 0.48 from 1970 to 1997, but 0.83 from 1998 to 2002.
* Rather than rely on historical correlations, a more comprehensive and dynamic approach is needed in making asset allocation decisions.   WTF kind of cliff hanger is that?
 
Here’s his next paper:
Emphasizing Low-Correlated Assets: The Volatility of Correlation by William J. Coaker II
• The fact that correlations change is well known. But the severity of change, and which relationships are subject to change, needs to be better understood because it has important implications for containing risk.
• This study evaluates the volatility of correlation among 18 asset classes to each other to determine the consistency or inconsistency of relationships.
• In the asset allocation process, some assets often are used together even though diversification benefits have been very low. (high correlation = low diversification benefits) For example, the correlations of the S&P 500 to large growth, mid-blend to mid-growth, small blend to small growth, and large value to mid-value, have been very strong.
• Several assets often are neglected in the asset allocation decision, even
though their diversification benefits have been very high. Natural resources, global bonds, and long-short, for example, stand out as having consistently low correlations to all the other assets in this study.
Growth and blend styles are highly correlated, and using them together does little to reduce risk.
Real estate, high-yield bonds, U.S. bonds, and long-short are more closely linked to value investing than growth. Emerging markets are somewhat more connected to growth than value.


• The asset allocation decision should emphasize low-correlated assets that satisfy return objectives. Two sample portfolios for different style investors show how risk and return are improved by combining lower-correlated assets.
 
What am I to make of this?


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ysette9

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Re: What am I to make of this?
« Reply #1 on: December 07, 2016, 08:49:12 AM »
My take on all of that is that it is unnecessarily complicating your assessment of asset allocation and scaring you with un-actionable information to boot. Yes, diversifying in uncorrelated assets is a good way of reducing volatility in your portfolio. Yes, correlation relationships between asset classes could change over time. However, you don't know how they will change and trying to predict how they might change and what the winners and losers will be is probably a fool's errand. Very educated, smart people do this stuff all day long and get it wrong all the time.

There is an implicit assumption in your post that volatility is a bad thing. I think it depends on your personal situation. If you are in the accumulation phase and are disciplined enough to not panic and sell in a dip, volatility is just an interesting graph to look at from time to time when you chart your net worth. If you don't have that kind of self control and need a steady portfolio balance to sleep well at night, then a more conservative and diversified asset allocation is the way to go. If you are already FIRE then there is a whole different set of considerations to take into account, including your time frame, risk tolerance, other sources of income, spending, etc.. Volatility in drawdown can be a problem (see discussions of sequence of returns) but can also be managed through various ways.

In short, I think you should set those papers aside and focus on more fundamental self education about investments (Bogleheads wiki investment startup kit, write your own Investment Policy Statement, JL Collins' stock series, Vanguard white papers, etc.) and create a stable asset allocation you can stick to during market ups and downs.


JustGettingStarted1980

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Re: What am I to make of this?
« Reply #2 on: December 07, 2016, 10:38:54 AM »
Simplify --> KISS

US Equity and US Bonds do not correlate. Use both of these. If additional diversification is desired, add International Equity with consideration of Global Bonds.

This is called the 3 (or 4) Fund Portfolio. It's really easy to maintain, and has the goal of "capturing the market" only, not beating the market, at very low expense ratios.

Best of luck to you,

JGS

FrugalFisherman10

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Re: What am I to make of this?
« Reply #3 on: December 08, 2016, 11:37:33 AM »
Appreciate the replies, both of you.
I have read JLCollins entire stock series, and I actually am posting these papers and discussion referencing a thread that is linked in the bogleheads wikis, while seeking information on establishing an IPS for myself.

(With all due respect, I'm likely "beyond" 'focusing on more fundamental self education about investments', or recognize I'm at the least in the process of doing so).
I believe JLCollins stuff (and many others) about 90 to even 100% equities, and have looked at the performance of that portfolio myself (on tyler's website,  portfoliocharts.com.) That's what im invested in right now, and will be for the foreseeable future. But the past is no guarantee of the future and I just don't know that the US equity market will continue to be what it has been for the last 100 years over the next 100 years. Gave me the impetus to start exploring other portfolios, albeit more complicated, but perhaps worth it.

Can a market be efficient if it's investors are not 100% rational? Can an investor be 100% rational if he doesn't know the correlation of the assets in his portfolio?
 
'Unactionable' - yes. That's why I was wanting someone's take on it.

Alas, this is becoming more of a 'journal' type post, and I'm not really looking for specific responses to these abstract questions

https://www.bogleheads.org/forum/viewtopic.php?p=25114#p25114


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« Last Edit: December 08, 2016, 11:44:10 AM by FrugalFisherman10 »

Car Jack

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Re: What am I to make of this?
« Reply #4 on: December 08, 2016, 01:24:35 PM »
I'll echo what JGS stated.

When I first considered index investing, I had to convince myself that index funds were not inferior in performance to the active funds I had (randomly) chosen in my 401ks over the years.  They were.  Then I had to pare down what I owned, figure out my starting point AA, build an excel spread sheet to even figure out what the heck I had and then do a whole lot of sell-to-buy actions. 

What I now have is a 3 fund low cost DIVERSIFIED portfolio of index funds.  The diversification part is very important.  When Company X goes out of business, the large number of company stocks owned makes it a "who cares?" event.  I don't even care about coorelation (stocks vs bonds) and have seen both go up and both go down together, so they don't completely counter each other.

Something not stressed enough is "LEAVE YOUR INVESTMENTS THE HELL ALONE!!!".  I heard that Fidelity did a study of their 401k owners to figure out who got the best returns.  Wanna guess who?  The active fund people?  No.  The index fund people?  No.  People who used advisors?  No.....  The people who consistently beat all other groups were people who were (wait for it)......dead.  Yes, dead people don't screw with their accounts.  They don't try to beat the market.  They don't even call up their advisor to ask them about the new, cool thing that's going to make them tons of money because....well....they're dead.

A good, simple, well diversified low cost portfolio in an appropriate asset allocation is wicked boring.  I mean wicked boring.  That's what it is.  If you want excitement, go find the hatch door to the roof of your building.  Go onto the roof.  Find a tree that's close enough to the roof that you can jump to it.  Do it!  Jump to the tree.  Now climb back down to the ground.  Exciting?  Yes.  Screws with your portfolio and kills your returns?  No.

DieHard_772

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Re: What am I to make of this?
« Reply #5 on: December 08, 2016, 04:33:30 PM »
Yes, correlation relationships between asset classes could change over time. However, you don't know how they will change and trying to predict how they might change and what the winners and losers will be is probably a fool's errand. Very educated, smart people do this stuff all day long and get it wrong all the time.

+1
Market timing is basically impossible... or at least, that's the attitude I keep in mind.  As Jason Zweig put it... "I don't know and I don't care."
Meaning, I don't know what is going to happen in the market... and I am not going to waste my time trying to anticipate the unanticipatable.
As I understand it, the purpose of diversification is REDUCING risk... not eliminating risk.  You can't actually eliminate risk... at least in the short run. With reward comes risk.  That's how it is.  However, over a long enough time horizon you can greatly reduce the risk, because the standard deviation of returns in the stock market gets smaller and smaller.  So over 20 years there is a much smaller range of possibilities, meaning much less risk of losing money, than say 10 years, or 5 years.