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. continue reading rest of the article….