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Actual Diversification

Actual Diversification

The prevailing investing wisdom of Modern Portfolio Theory promotes that risk can be minimized through diversification. The broader the diversification, the better off the client will be. This is based on the assumption that not everything can go down at the same time. Attempts at diversification are often made by investing in a broad collection of non-correlated asset classes. This means that such assets have the appearance of not being tied to one another. One asset goes up while another goes down. The goal is that more assets increase in value than decrease in value over time. This is more perceived than actual diversification. Perceived diversification can be dangerous in a down market.

Actions taken in one area can often impact other areas. Not all assets are correlated in the same way all the time. Since markets can now become correlated with very little notice, this approach can be risky. In a bad market, everything goes down, as investors abandon their positions and move to cash – usually after taking a huge loss.

For instance:

  • Small stocks are often highly correlated with large and mid-cap stocks.
  • Market action in one country is often highly correlated with what is happening in another country.
  • Assets defined as diverse or non-correlated can all move down at the same time.

To achieve actual diversification, tactical investment management should use the proper methodology and time frame variation to design each investment strategy. Specific market baskets representative of the sectors with the strongest momentum are created. Underwater correlation studies are done to determine how correlated one methodology is to another methodology during a downturn.

Underwater Correlation Analysis

Underwater correlation is a better calculation to use compared to traditional correlation. There is little concern if all asset classes are performing well together. However, there is concern if they are all declining at the same time.

While general correlation has some merit, tactical management puts a stronger emphasis on underwater correlation. This indicates the extent of correlation between different asset classes or methodologies during periods of drawdown. Asset classes or return streams, which appear uncorrelated during market upturns, can easily become correlated during market downturns.

The advantages of underwater correlation analysis are it:

  • Combines methodologies that are not correlated during drawdown periods
  • Focuses on correlation when it matters most, during draw downs, instead of during upturns

The results are well-designed strategies stemming from well-planned models of specific markets. The strategies then blend a variety of ETFs, index funds and other mutual funds. Portfolios are customized by combining the strategies based on the needs and time horizons of the individual client.

Market Basket Variation

A market basket can become the potential selection of investment for a given methodology. Because of this, constant evaluation of all asset classes and market sectors need to be maintained. This is in contrast to having fixed allocations to stock and bond markets.

Different market baskets can manage the risk vs. return component of a methodology. For example, adding bonds to the basket can decrease risk and return, whereas adding commodities can increase risk and return.

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