Why You Want Your Investments to Dance Like Elaine Benes, not Ginger Rogers and Fred Astaire

astaire_rogers_waltzinswingtime.gifA reader (we’ll call him Al since that’s his name) wrote a great comment in response to my article, Asset Allocation for Near and Active Retires, which is part of a longer series on Asset Allocation. Here is Al’s comment:

Hi – I don’t know when Ferri wrote his book but my guess is that these asset classifications had lower correlations both among themselves and compared to the S&P 500. I thought that a key element of asset allocation was diversification with there being low correlation among asset classes. Any comments on this element of asset allocation?

Al is absolutely right that low correlation among asset classes is critical in any portfolio seeking diversification. Correlation refers to how different asset classes perform, relative to one another. That is, do they dance like Ginger Rogers and Fred Astiare, in perfect lock step? Or do they dance more like Elaine Benes from The Seinfeld Show? Correlation is measured on a scale from -1 to 1. A correlation of -1 means that when one investment goes up by a $1, the other goes down by a $1. Think Elaine Benes. A correlation of 1 means that when one investment goes up by a $1, so does the other. Think Ginger Rogers and Fred Astaire. A correlation of 0 means that the two asset classes have no correlation with one another. One of the goals in asset allocation is to assemble a collection of asset classes that have a low or negative correlation.

Why?

The theory behind asset allocation is that we can add riskier assets to a well diversified portfolio that will increase our returns while actually decreasing our risk. There are many good books that describe this theory, and here are three that I recommend:

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Ferri’s Model Portfolio

So now the question is whether Ferri’s suggested portfolio for near and active retirees included assets with low correlation. I should say here that it is getting harder and harder to find assets classes with low correlation. With the globalization economy, international and domestic markets are moving more in lock-step than ever before. That said, low correlation among several asset classes is still achievable. Ferri’s portfolio includes four basic asset classes: U.S. equities, International equities, real estate and fixed income. The correlation among these asset classes will vary depending on the time period considered. From 1989 to 2001, according to The Art of Asset Allocation : Asset Allocation Principles and Investment Strategies for any Market, U.S. large cap equities had a correlation with International equities of .56. REITs had a correlation with large U.S. equities of -.03 and fixed income had a correlation of about .5. So generally, Ferri’s suggested portfolio does achieve relatively low correlation among the various asset classes he suggests, at least as measured by recent data.

If you think Ferri or I have missed it here, leave a comment. And remember, when thinking about asset allocation, think Elaine Benes:

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Published or Updated: March 11, 2014
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Al Brockman says:

    Hi – Thanks for the nice comment. My frustration is that the Ferri data is for the period through 2001. My layman’s guess is that the impact of globalization really hit after 2001. If true, then the correlations are probably much higher since then. I don’t want to harp on this element of asset allocation but how do you find asset classes with low current (e.g. 2001-2006 correlations? Obviously, fixed assets should have a very low correlation – but the recent returns have been less than stellar.
    Another element – I’m not sure why the retiree’s portfolio would be different from the mid-life portfolio. It used to be suggested that there should be a quantum shift after retirement from equity emphasis to fixed assets. The problem in today’s world is that a person retiring at 65 probably has a retirement period of as long as 20 years. He or she should still be looking at a longer term planning/investing horizon.

    Any comments?

  2. DR says:

    Al, I do think the asset mix should be different for mid-lifers than those at retirement. I agree that even at 65 one may have an investing horizon of 20 years or more (at least we hope). The difference, however, is that a retiree has an immediate need for cash, while a mid-life does not. Therefore, I think a shift toward more fixed income is necessary to meet the short-term cash needs of retirees. Full Disclosure: I’m a mid-lifer, so maybe I’ll view it differently in 20 years. As for recent correlation, I’m researching the question now and hope to post a response tomorrow. Best, DR

  3. Al Brockman says:

    Thanks for the reply. You’re generally right, particularly if the portfolio is the primary/only source of income. However, there are reasonable growth alternatives to the traditional fixed asset ladder. ETFs such as PID or some others are meant to give a reasonable dividend plus, in a decent market, provide some growth of principal. However, with that choice comes additional risk.
    Again, thanks for the comments on my comments.

    Al

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