Play Your CARDs Right

Correlation

In the world of finance, correlation is a statistical measure of how two securities move in relation to each other. We do extensive correlation research as we think about risk and returns in clients’ portfolios.

Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.

A well balanced portfolio will have multiple asset classes that have low correlation to one another. When done correctly, the art and science of blending a variety of low correlated asset classes allows a portfolio the opportunity for a smoother ride than otherwise possible with a more concentrated blend of asset classes. If a portfolio is diversified among asset classes that are all perfectly correlated (+1), there is no benefit to the diversification. Correlation is the power behind diversification.

Goodness is the only investment that never fails.

– Henry David Thoreau

Asset Allocation

An asset class is a group of securities that exhibit similar characteristics, that behave similarly in the marketplace, and that are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments), however when Equitas researches and constructs a portfolio, we include as many as sixteen different classes. They may include international securities, MLPs, real estate, and commodities among others.

The terms asset classes and asset class categories are often incorrectly used interchangeably. In other words, describing large-cap stocks or short-term bonds as asset classes is incorrect. These investment vehicles are asset class categories, and are used to increase diversification.

Each asset class is expected to reflect different risk and return investment characteristics, and will perform differently in any given market environment. Using multiple asset classes in portfolio construction helps achieve a lower risk, less correlated portfolio, and it is the first step in diversification. Our return attribution analysis indicates that proper asset allocation is the most powerful tool in portfolio construction.

The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.

– Sir John Templeton

Rebalancing Reduces Risk – The Three “Rs”

To rebalance is to bring a portfolio back to its original asset allocation mix. Though it may feel counterintuitive, rebalancing entails selling winners and buying underperformers. This is necessary because over time, allocations to asset classes and individual managers become out of alignment with investment policy guidelines. Some asset classes will grow faster than others. Rebalancing ensures that a portfolio is not over or under weighted in relation to guidelines. By selling outperformers and reinvesting in laggards, a portfolio locks in its gains, and re-invests in underperforming sectors while they are “on sale”. As long as the initial investment thesis still rings true, and there is no fundamental change in a manager that may require putting them on a “watch” list, buying on dips is a great way to reposition a portfolio for increased alpha.

There are three different methods to rebalance a portfolio:

• Periodic: Pick a period, such as annually, and sell investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.
• Event Driven: Whenever an asset class falls out of the acceptable range noted in the Investment Policy, rebalance the portfolio back to the Policy’s Target allocation.
• Cash Flow: Use new contributions and withdrawals to rebalance the portfolio. Purchase new investments from cash flows with-in the portfolio to buy under-weighted asset classes, and make the sales from the appreciated, over-weighted asset classes.

The Cash Flow method is the smoothest for money managers. Event Driven has the greatest impact on performance. We use all three methods at Equitas. Regardless of how it is achieved, a portfolio should be rebalanced on a regular basis in order to optimize returns. Equitas monitors clients’ portfolios continually to seize rebalancing opportunities.

Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.

– Warren Buffett

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. In other words, investors need to be compensated for taking on additional risk.

For example, a U.S. Treasury bond is considered to be one of the safest (risk-free) investments and, when compared to a high yield bond, provides a lower rate of return. A corporation that can only borrow in the “junk” market is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a junk bond is higher, investors expect a higher rate of return.

A well-constructed portfolio consists of multiple asset classes that are positioned on various spots on the risk return spectrum. When done correctly, this lowers overall portfolio risk while optimizing returns. The whole portfolio becomes safer than the sum of the parts.

Money is like manure. You have to spread it around or it smells.

– J. Paul Getty

Diversification

Diversification is a risk management technique that mixes a wide variety of asset classes within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the asset classes and managers in the portfolio are not perfectly correlated.

Our asset allocation studies have shown that maintaining a well-diversified portfolio of asset classes and managers yields the most cost-effective level of risk reduction. We strive to provide the lowest possible level of volatility that still allows a portfolio achieve its return targets.

Diversification benefits are gained by investing in asset classes that have low correlation to one another. For example, an economic downturn in the U.S. economy may not affect Japan’s economy in the same way; therefore, having Japanese investments would allow an investor to have a cushion of protection against losses due to an American economic downturn. This happened very effectively in the decade of the 1970s.

Most investors wait for investments to go up and then they buy after the investments have appreciated. Investors tend to buy what they wished they had bought. Conversely, they sell after the investment has gone down. Correlation, Asset Classes, Rebalancing, and Diversification are tools to help avoid these problems. Playing your CARDs right can keep you from falling into these traps and yield a more prosperous investment experience. Equitas Capital Advisors is proud to serve as your investment management consultant. We appreciate your business, and value the trust and confidence that you place in us. We look forward to continuing to engineer and deliver investment solutions to you for years to come.