Portfolio Management 101: Don't Stray from the Market

Roger Nusbaum submits: A good question came in about how to integrate assets with low correlation into a portfolio. He notes that gold always comes up as a way to diversify, but the long-term track record of gold is not very good. There is an opportunity-cost there, and he wonders about how much impact these holdings can have unless they take up a huge part of the portfolio.

The answer ultimately lies with the individual. One bit of context has to be that the market goes up the vast majority of the time. I have seen the number as 72%, but one reader noted the market has an up year 78% of the time. You get the idea.

I mentioned my generic portfolio having a correlation of 0.78 to the S&P 500. If the market goes up seventy-whatever percent of the time, you don't want to stray too far away from some U.S. benchmark as a starting point for construction.

Things I write about are an attempt on my part to explore market equaling returns with less volatility. More importantly the typical client that hires a money manager (this is who I serve after all) is often less tolerant of downside volatility.

I do not think it takes a lot to take a portfolio away from the S&P 500. A portfolio that is 80% invested in a diversified portfolio that then buys a double-short fund with its 20% cash the correlation down to 0.85, according to PortfolioScience.com. That may not seem big, but this was only one trade.

In the above example, assume the long portfolio was a position in S&P 500 Index (SPY) but with some foreign, a bit of gold, and maybe some REIT exposure -- the correlation might come down to 0.70.

This entire concept becomes more important the less tolerant of volatility you are. Most clients want less volatility. I personally want less volatility because, as I have touched on before, my livelihood depends on the market. While I do not get emotionally worked up by the ups and downs, I don't want to press this too much and let emotion get in the way of my job.

As a do-it-yourselfer, you may have other considerations that make you want more or less volatility. Gold is itself very volatile, but when owned in a reasonable proportion in a diversified portfolio, it serves to reduce volatility.