Diversifaction Redefined

The level of correlation between asset classes has important implications for assets allocation and risk diversification.  Traditional diversification models suggest that someone should have about 25-30 stocks and invest in various asset classes (e.g.: Large Cap US, Emerging Countries equities, Real Estate Investment Trusts, Commodities, Bonds, etc). 

While there is some merits to these concepts, many of us knows that they are of little help when the market crashes like in 2008.  Traditional diversification among equity like asset classes (e.g.: Sectors, Geography, REIT, etc) is of limited use to reduce portfolio drawdown since correlations among these asset classes typically spike during market panics. 

Even the old principle of investing 60% of a portfolio in stock and 40% should be requestioned.  This principle suggests that even though bonds typically yield a lower return than stocks over the long-term, they would be justified to reduce the overall risk of a portfolio because of the low correlation between the two asset classes.  However, few people knows that the correlation between the two is not stable, and changes over time which has important implications in determining the optimal allocation.  A higher correlation implies a higher allocation to equities, given that bonds generally have lower expected returns. Various factors have an impact on the stocks/bonds correlation (i.e.: stocks market cycles, interest rates, inflationary expectations) but what is more important to remember is that, as illustrated in the graph below, the correlation has been rising since 2003 and thus the need to review the amount allocated to bonds. 

Graph 1 – Stocks-Bonds Correlation
As a reminder, a score of 1 represents asset classes fully correlated while -1 are two assets classes moving in the opposite direction.

 

The real question is if there is a better way to reduce a portfolio volatility than the traditional diversification techniques.  The answer is yes.  By combining four investment strategies and having a significant portion of the index invested in short positions, TQI has been able to produce high return with a level of risks much lower than the market, regardless of market conditions.

Sources:
The Stock-Bond Relationship and Asset Allocation
Diversification: A Failure of Fact or Expectation?

Disclaimer: For general information purposes only.

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