Seeking Alpha
Profile| Send Message|
( followers)

Constructing a sound portfolio is vital for long-term investment success. Holding assets that have high expected returns and are not correlated with each other are two key factors for a portfolio's returns and risk management. The second factor is usually called diversification. Mathematically, diversification is measured by how much the holdings in a portfolio are correlated. Many beginners mistaken diversification as the number of holdings or take comfort in holding many funds or stocks in a portfolio. However, a real measurement is the pair wise correlations among holdings and their overall resulting standard deviation of the portfolio.

Harry Browne's Permanent Portfolio has been a good example to show how to construct a balanced portfolio using assets that are radically different: it consists of mainly 4 assets: U.S. stocks (SPY or VTI), Long-Term Treasury Bonds (TLT or IEF), Gold (GLD or IAU) and Cash.

The following shows how the 3 active assets (stocks, long-term bonds and gold) were correlated in the past 5 years.

(click to enlarge)

Two observations:

  • Other than a brief period in 2010, there was always at least one pair that had negative correlation.
  • Most of the time, there were two pairs of negative correlation and one pair positive correlation.

The negative correlated pairs of assets hedged with each other. They helped the portfolio to navigate through many market crises in the past 30 years of permanent portfolio history. A perfect instance is the financial crisis from late 2008 to early 2009. In the period, permanent portfolio had at least two assets that were negatively correlated, carrying the portfolio through the disaster with relatively low drawdown.

For the long history of permanent portfolio, one can see this link. Year to date, the portfolio had a return of 6.9%.

Using long term Treasury bonds (TLT or IEF) as a portfolio hedge is also adopted by Yale endowment manager David Swensen. See David Swensen Six ETF Asset Individual Investor Plan for more explanations on the rationale behind it. First Eagle funds have been also very successful in using gold as a portfolio hedge.

In a short term, no one can guarantee all of the assets in a portfolio can hedge with others. This leads to another important and last-resort principle in portfolio construction: having an acceptable risk (profile) for a portfolio. To protect a big drop in one day or week or even one month, such as the one in 1987, one cannot rely on diversification alone. You have to distinguish between risk and stable assets. Because of the nature of their underlying economic values and markets, bonds, especially U.S. government-backed bonds in the recent history, tend to withstand market disaster much better.

It should be noted that correlations (or diversification) alone is not good enough to construct a good portfolio. It has to consist of assets with high expected returns. For example, in the permanent portfolio, U.S. stocks have long-term average annual total returns of 7.8% (nominal returns with 2.8% inflation) while 20-year long-term U.S. Treasuries have about 4.6%. All are based on Rick Ferri. See the Bogleheads' excellent wiki page on this subject. Historically, gold also exhibits a similar return like stocks. All of these can help one to derive a ball park average expected returns for your portfolio.

The take away from the above is that one can use correlations among holdings in a portfolio to help understand how well a portfolio is diversified. Readers interested in this topic can look at the Asset Trends & Correlations page for the up to date information on major asset classes.

Disclosure: I am long SPY, GLD, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Asset Correlations As A Guide To Portfolio Construction