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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