From the Archives: Diversification Mixup

March 13, 2012

One of the principles of strategic asset allocation is that you can reduce your risk by combining assets that have low or negative correlations.  It requires the correlations between asset classes to be stable.  Unfortunately, that is not the case.  As a recent article in the Wall Street Journal points out:

As stocks retreated and recovered in the past 15 months, commodities investments moved in step with the U.S. market.

That wasn’t supposed to happen.

Investing in commodities long has been pushed as a useful way to cushion portfolio risk. “We haven’t seen the independence [in commodities returns] that you’d hope for in a diversified portfolio,” says Jay Feuerstein, chief executive of Chicago commodity-trading adviser 2100 Xenon Group.

This time, instead of moving independently of stocks, commodities have moved almost in lockstep with equities.  The diversified portfolio you thought you built really isn’t diversified at all.  To my way of thinking, this argues strongly in favor of tactical asset allocation where the portfolio is based on the current behavior of the individual components and not on some pretend correlation.

—-this article was originally published 12/29/2009.  Tactical asset allocation is still a good way to deal with some of the problems created by changing correlations.

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The Cart Before the Horse

March 13, 2012

Consumer credit is closely linked to economic performance.  And when there is economic data lying around, you can be pretty sure that there is an economist trying to predict the stock market with it not far behind.  Not long ago, we had a post that showed how the stock market led even the Leading Economic Index.  The other day I saw a post at the always wonderful CXO Advisory correlating consumer credit with the stock market.  Once again, it’s the stock market that leads, not the economy!

…annual stock market returns have a positive relationship with next-year consumer borrowing, explaining about 6% of next-year changes in consumer credit.

One might hypothesize that when the market goes up, people feel better about the economy and are willing to borrow.  CXO provides a nice chart showing the relationship with the regression line.

Follow the Leader

Source: CXO Advisory  (click to enlarge)

All of this is a good reminder: when you are dealing with the market, pay attention to market prices.  Economic linkages often lag and assumptions about how they are linked to the market are often incorrect.

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7 Questions to Consider When Doing Asset Allocation

March 13, 2012

Here are seven questions that can lay the foundation for a fruitful relationship between a financial advisor and their client:

Question #1:  What investments make up your investment universe?  Does your investment strategy allow you to invest in a broad range of asset classes, including U.S. equities, international equities, currencies, commodities, real estate, and fixed income?

Question #2:  What role do current market conditions play in the asset allocation decision-making process?  Does your investment strategy have a means of increasing exposure to asset classes in secular bull markets and decreasing exposure to asset classes in secular bear markets?

Question #3:  Does your portfolio include investments in complementary strategies?  Relative strength and value are both long-term winning investment factors.  They also tend to have low, or even negative correlations to each other, thereby providing useful diversification.

Question #4:  Is your asset allocation divided into segments?  Breaking a portfolio into an income segment, balanced segment, and growth segment can provide tremendous psychological benefits and therefore may increase the odds that you will stick with your investment plan over time.

Question #5:   Do you have a plan for systematic contributions?  There are many ways to accomplish this goal, including setting up a monthly automatic withdrawals from your bank to your brokerage account or regularly sending 15% of every dollar earned to your brokerage account, but the key is to have some systematic means of continuing to save money for your financial goals.

Question #6:  Do you have a plan for how you will approach distributions from your portfolio during retirement?

Question #7:  Do you have a financial advisor that will give you the TLC you will need to be educated and guided along all the inevitable bumps in the road?

Some relevant resources:

Savings or Growth? 

Expected Returns

Safe Withdrawal Rates

What’s Your Retirement Number?

Strategic Allocation Bites

The Upside of Mental Accounting

The Bucket List

Combining Global Macro & MDLOX

Why Tactical Asset Allocation

What is a Balanced Fund, and Why Should You Care?

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What’s Hot…and Not

March 13, 2012

How different investments have done over the past 12 months, 6 months, and month.

1PowerShares DB Gold, 2iShares MSCI Emerging Markets ETF, 3iShares DJ U.S. Real Estate Index, 4iShares S&P Europe 350 Index, 5Green Haven Continuous Commodity Index, 6iBoxx High Yield Corporate Bond Fund, 7JP Morgan Emerging Markets Bond Fund, 8PowerShares DB US Dollar Index, 9iBoxx Investment Grade Corporate Bond Fund, 10PowerShares DB Oil, 11iShares Barclays 20+ Year Treasury Bond

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