Asset Allocation Can Be Deceptive

Asset Allocation, as promoted in most investment books, does not automatically translate into a well-diversified portfolio.  Most investors think their portfolios are well-diversified if they hold stocks in each sector of the market or cover most of the ten to twelve major asset classes.  This is one time smart investors need to beware of intuitive feelings as they are likely to lead to incorrect conclusions.

To illustrate, this morning I’ve been reviewing a portfolio that has been in operation nearly ten years.  The portfolio currently covers asset classes such as the “Big Six” U.S. equities, REITs, developed international markets, emerging markets, bonds, and cash.  There are 15 ETFs in the portfolio to cover these asset classes.  This certainly appears to be a well-diversified portfolio considering the major asset classes are incorporated and all the market sectors are represented in this portfolio.

But what are the facts telling us.  Running an analysis of this portfolio, I find that 12 of the 15 ETFs have a correlation, when compared with the portfolio as a whole, of 90% or greater.  The REITs and international ETFs have correlations that are just a tad under 90% and the bond ETF has a negative correlation.  The bond ETF is the single exception in this “broad-based” portfolio.  Based on the facts, this is not a well-diversified portfolio.  Do not be lulled into thinking your portfolio is well-diversified simply by purchasing ETFs in different asset classes.  Surprising as it is to most investors, it is possible to pick up one stock that adds more diversification to a portfolio than does adding one ETF.  It depends on the stock and the ETF.  Portfolio construction is more complex than most investment books and articles indicate.

Lowell Herr

Photograph: Local flowers.

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