A 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.
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:
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: