Thread: Diversification??

Interesting, but not surprising.

Small cap stocks have always been highly correlated with the S&P 500.

At times, international large cap stocks are highly correlated with the S&P 500. At other times, they are less highly correlated.

Historically, bonds and T-bills have a low correlation with the S&P 500.

Good diversification requires holding asset classes that have low correlations.

...which in our case is G and I. D

And F.

Can someone take me to school on this one? I'm pretty new to the game.

Isn't everything positively correlated because just about everything is doing super well for the past few years? Is the market not allowed to be this awesome all over the spectrum some of the time? Does the fact that Small Cap Foreign Stocks being postively correlated to Domestic Blue Chips have to mean something or couldn't it all be a big coincidence?

Moreover, if I'm not diversified by putting a little into Large Caps, a little less into small caps, and a hunk into Foreign, how do I diversify? Do I invest in negatively correlated sector funds? A little in Financials, some Science and Tech, and some more in... something else?

Diversification: an investment strategy designed to reduce exposure to risk by combining a variety of investments, such as U.S. stocks, international stocks, bonds and cash, which are unlikely to all move in the same direction.

Diversification according to William O'Neal is a way for an investor who doesn't know what he is doing to cover his but!!!

Well, that seems to include everone but "whats his name"!....

C and S are highly inter-correlated because they are the two sides of the same coin representing the total U.S. market.

C/S (taken together) and I and somewhat inter-correlated because the different regions of the global market affect one another. Example: Japan might go down because of a bad day on Wall St, or Wall St might go up if Japan has had a big day. Currency fluctuations may reduce or even reverse the correlations, enhancing the effect.

C/S/I and F are somewhat (negatively) inter-correlated in that when one goes up the other goes down, usually. Example: rising interest rates cause C/S/I to suffer but F goes up, and vice-versa.

G = cash. This is a fixed-income account which correlates only to itself and thus represents the best opportunity for diversification that is available to us, in terms of asset class.

Thus G and I are the two funds that are the least-intercorrelated. Theory would pick those two as the means to diversify.

The problem is that maximizing diversification in this way means you have totally abandoned the U.S. market, which is the world's single largest economic engine.

So, in practical terms, diversification means taking a position in several funds. Or, using the TSP in conjunction with our outside accounts to achieve same.

Dave

DaveM,

Many good points. I approach diversification as a family unit. I use my TSP account to try and leverage as much as I can by being concentrated with as many shares as I can accumulate - where the C fund goes I follow. I've been easing back on my small cap fund and adding to the international - which belongs to my wife in her defined contribution account. My account at Merrill hit me over the head the last three days - but no matter I enjoy the pain of lower prices and plan to do some buying Monday. It's hard to pass up these types of opportunities - this market has good support underneath it. We will now spend time building a base from which to get up and over Dow 11,722.98.

Originally Posted by fuzzduzz

Diversification according to William O'Neal is a way for an investor who doesn't know what he is doing to cover his but!!!

exactly...the next step, more proactive approach, would be 'sector rotation'.

Originally Posted by shiftomnimega

Can someone take me to school on this one? I'm pretty new to the game.

Moreover, if I'm not diversified by putting a little into Large Caps, a little less into small caps, and a hunk into Foreign, how do I diversify? Do I invest in negatively correlated sector funds? A little in Financials, some Science and Tech, and some more in... something else?

Spaf’s definition is right on. In addition, you’re correct, you are diversified. However, if you leverage non-correlation between asset classes or sectors you can gain a diversification bonus. In other words, correctly constructed, your portfolio can provide a higher risk adjusted return.

The attached is a Mean-variance optimization (MVO) of the TSP funds. Harry Markowitz received a Nobel Prize for MVO. The curved line on the graph is the efficient frontier. All efficient TSP portfolios line on this curve (based on the historical inputs). I used historical data (returns, standard deviations, and correlation coefficients) from 1992-2005 to produce this graph.

#3 is the C Fund. As you can see, a combination of F, C, and S Funds provides the same return as the C Fund (11.66) with lower volatility (17.97 vs. 16.48). Consequently, combining asset classes that are not perfectly correlated provides a superior risk adjusted return. You can receive a C Fund return at lower risk than the C Fund. Finally, you can construct the optimal portfolio for any level of return or risk.

If you'd like the MVO input data, I'd be happy to provide it.------Rokid