Re-thinking Asset Allocation and Correlation

July 26, 2010 by  
Filed under Investing

A bedrock principle of asset allocation for the long term investor is asset correlation. The theory is that a properly allocated portfolio includes investments in different asset categories or classes that are non-correlated. This means that as general market and economic conditions change, the different asset classes won’t experience a lockstep change in value. In other words, you don’t want the value of all of your investments to rise and fall together, particularly the “fall” part. 

You don’t want pure anti-correlation either, where your different asset classes always move inversely to each other. Preferably, your investments would change in value in a somewhat independent fashion. This gives your portfolio an opportunity to thrive in good times and to survive in bad times, without a need for constant buying and selling.

There is a problem developing with practical implementation of a portfolio based on an asset non-correlation theory. The problem is that stock correlations are now ridiculously high, at 0.82. This is higher than since 1982, except for the “crash of 1987″ period. To bring even more attention to this situation, here is a recent quote from the Seeking Alpha site:

Over the nearly 40 years of data, there have only been a total of three readings over 0.80 (including the current reading) and only five reading over 0.67! Thus, the current correlation of stocks to the market is indeed quite rare.

What does this mean for the average investor? In one sense, it warns you that all of your perceived stock-picking skills may be to no avail. When a highly-correlated market falls, your picks are likely to tag along, no matter how clever you think you have been.

What can you do to respond to this situation? I’ll tell you what Mr. ToughMoneyLove has done.

First, I checked the relative correlation of our long term holdings. That is easy to do by plotting their respective market movements during the past year (or other period) on a chart. You can quickly do that displaying a Google Finance chart for one of your holdings, then use the “Compare” box to add additional investments from your portfolio to the chart.

When I did this for our ten speed “couch potato” portfolio, I observed that too many of the ten different asset classes were moving in tight correlation. This was not how it was when I first set up the portfolio in 2007.

What I did next was to reduce the number of different investments in the portfolio. I chose asset classes that were consistent with a long term “couch potato” investment plan and that were generally non-correlated. A related motivation was to make it easier to manage risk and to lower transaction costs by using stop loss orders.

If you are a long term investor, I suggest that you investigate the correlation (in today’s market) of your different asset classes. If they are tightly bound together, make a change. If you don’t, you are losing the benefit of owning different classes of investments and increasing your risk.

Or do you have a better idea to share?


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3 Responses to “Re-thinking Asset Allocation and Correlation”
  1. Rob Bennett says:

    Or do you have a better idea to share?

    The model in which all of the conventional investing wisdom is rooted is flawed right to its core, Tough Money. People have a hard time taking this in.

    The fact that the model is flawed does not mean that there is nothing at all to much of the conventional wisdom. In many cases, the flaw causes us to see things that really are there in a mixed-up sort of way. Many of our fundamental beliefs about investing are half-truths.

    The flaw is the failure to take valuations into account (the Efficient Market Theory posits that both overvaluation and undervaluation are logical impossibilities because rational investors should want to price things properly). It makes all the sense in the world to own a mix of different types of assets, some of which will do well when others are doing poorly. The problem is that, if you fail to take overvaluation into account, all may be going down at the same time (just some less than others).

    When overvaluation gets as out of hand as it did in the late 1990s, it is possible to have a situation in which just about every asset class is going to be going down at the same time. The answer is to look at valuations before investing and to encourage everyone else to do so. If all took overvaluation into account, we could never get into this sort of situation. It is Buy-and-Hold (the idea that you don’t need to consider valuations when setting your stock allocation) that caused the problem.

    We have to get to a point where we all feel free questioning Buy-and-Hold. Then we’re on our way to some great places.

    Rob

  2. I don’t bother with correlation, etc anymore. I let the price tell me what is going on. I do trend following with prudent money management, entry points, and exit points. It relieves me of trying to predict the future, worrying about news, politicos, earnings, and other things that affect an investment. It has certainly made my investing life easier and saner.

  3. MasterPo says:

    Isn’t the idea of index investing supposed to solve this problem (the correlation problem that is) based on the philosophy that over the long haul it’s rare to beat the overal market?

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