Asset Allocation and Diversification

Any prudent portfolio management process must include the principles of asset allocation and diversification. These are two tools available to us for our portfolio risk management. This has been said many times, presented many times, and we individual investors make mistakes. On a personal front I have been guilty of it. Asset allocation and diversification are two different aspects which have different objectives.

In true sense, asset allocation is different types of assets which are either non-correlated or at least have low correlation. The notion here is that if these assets have low correlation, the volatility in returns will smooth out. Table 1 shows the average correlation factors in 18×18 matrix for different asset class such as real estate, international stocks, emerging markets, high-yield bonds, U.S. bonds, long-short, and investing styles. Table 2 provides the standard deviation of these correlations.

Between these two tables, we can observe that there is low correlation between stocks, bonds, real estate, and natural resources. In addition, the emerging markets and international markets have relatively higher correlation of up to 0.6. Investment strategy that includes asset allocation in true sense will have these lowly correlated assets included in the portfolio. It is hugely unlikely that at a beginning, we may not have all assets. However, based on individuals risk profile, it surely can be build over time. Asset allocation is designed to smooth out volatility and average out growth of the portfolio.

Long Term Correlation (from 1970 to 2007)

Long Term Correlation (from 1970 to 2007)

Long Term Standard Deviation of Correlation (from 1970 to 2007)

Long Term Standard Deviation of Correlation (from 1970 to 2007)

These two charts also show there is relatively higher correlated between style of investing (e.g. growth, value, blend) and market capitalization (e.g. small cap, large cap, mid cap). These correlations range from 0.7 to 0.96. These types of assets with have higher correlation is used for diversification purposes. Diversification is designed to blunt the impact of any negative performance in a given sectors, industry, or investing style.

Both of these tools are for portfolio risk management. However, both have different approaches and implemented in different ways.

Another aspect of asset allocation is re-balancing. I have learnt this hard way. Until year 2008 my approach was to stop investing in any asset class or sector/industry and focus on under invested areas. Allocate new capital to under invested area. That is not a correct method. The correct approach is to selling partial position in good performers, and re-allocating the capital.

It can be argued that all these discussion of asset allocation and diversification can be tossed out based on what’s happened in 2008 and continuing in 2009. However, investor’s need to realize that investing is a long term process. The two or three years is a very small time period and does not reflect the true benefits of the asset allocation and diversification.

Next week I will present quarterly update on my portfolio which will include discussion of these two aspects. Stay tuned!!

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