Diversification Benefit of a specific asset class

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pop77
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Diversification Benefit of a specific asset class

Post by pop77 »

I am trying to simplify my overall portfolio, trying to assess whether the asset class I own provides any specific benefit or whether I should get rid of it and add the proceeds to another one. Is there a specific way to find diversification benefit of a specific asset class?

For example, I own 3% in Vanguard Real Estate (VNQ) and 3% in Vanguard International Real Estate (VNQI), I wonder whether I should just own VNQ.

In portfolio visualizer I try to see correlations of these funds to other asset classes I own. VNQI is negatively correlated to Vanguard Total Bond Market (VBMFX) but VNQ is negatively correlated to VIG (to represent my dividend growth stocks),Small Cap and VEA. On top of this, VNQ has lower annualized standard deviation and better returns not to mention lower expense ratio.

Asset correlations for the specified tickers
Ticker VNQI VNQ VBMFX VIG VSCPX VWO VEA
VNQI - 0.32 -0.09 0.17 0.38 0.82 0.68
VNQ 0.32 - 0.62 -0.09 -0.14 0.40 -0.24

Thoughts?
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nedsaid
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Re: Diversification Benefit of a specific asset class

Post by nedsaid »

This is a hard question to answer. Pretty much, I have thrown asset classes at the volatility problem without dampening volatility very much, if at all. TIPS, REITs, Emerging Markets, US Small Value, etc. The problem is that in a crisis, asset classes often don't act as expected. What worked brilliantly during the 2000-2002 bear market most decidedly did NOT work during the 2008-2009 bear market.

I can't help but notice how well simple 60/40 balanced funds perform over time. Simple, nothing fancy. The darned things do nothing but perform.

About all I can say is that there will be times that REITs and International Real Estate "work" and times that it doesn't. I wish I had a better answer.
A fool and his money are good for business.
Topic Author
pop77
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Re: Diversification Benefit of a specific asset class

Post by pop77 »

Good point. I think % Bonds is the key decision and provides most of the diversification, other slicing and dicing is all gravy..
kenner
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Re: Diversification Benefit of a specific asset class

Post by kenner »

pop77 wrote:Good point. I think % Bonds is the key decision and provides most of the diversification, other slicing and dicing is all gravy..
... or all wasted effort and mental energy. Unless, of course, you know more than the millions of investors who actually determine market prices.
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pop77
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Re: Diversification Benefit of a specific asset class

Post by pop77 »

I wonder whether there are any counter points from those who have multiple slices in their portfolio..
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nedsaid
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Re: Diversification Benefit of a specific asset class

Post by nedsaid »

pop77 wrote:I wonder whether there are any counter points from those who have multiple slices in their portfolio..
I suppose I am an asset class collector. What I have found so far is that "slicing and dicing" sometimes dampens volatility and sometimes it doesn't. REITs, TIPS, International Stocks, Small-Cap, Value all worked as effective diversifiers during 2000-2002. Precious metals stocks and even commodities worked then too. During 2008-2009, these asset classes fell and fell hard. TIPS fell just over 10% as did Corporate Bonds, they fell less hard than the other asset classes I listed. Pretty much US Treasuries and Agency bonds were the only things that worked.

Does small/value tilting improve portfolio performance? Depends on when you peek. It is time period dependent though over longer time periods (30-40 years plus) you should see the excess performance.
A fool and his money are good for business.
asif408
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Re: Diversification Benefit of a specific asset class

Post by asif408 »

Bogleheads is a type of religion :wink: , and you have varying degrees of Boglehadism. The fundamentalists will tell you index everything, don't slice and dice, you can't beat the market. There are others who are fairly active, and many in between who make small to moderate tilts to SCV, REITs, etc. IMO there is probably some benefit to some slices and dices, but only if you can stick with it through good and bad times. I also put fees at the front of the list, so I only add slices and dices that don't appreciably increase my costs to invest.

Correlations among stock asset classes do vary over time, and so diversification also varies with correlations. When correlations are high, diversification benefits are low, and vice versa. About the only reliable negative or 0 correlation is short-intermediate term, high quality bonds to stocks, which you already pointed out. Segments of stocks and bonds (emerging markets, REITs, commodities, precious metals (PME), junk bonds, etc.) do provide diversification from time to time, but it is not consistent like the diversification you get from high-quality, short to intermediate term bonds.

I think the best you can do is look at previous years performance and correlations and make rough estimates of potential diversification. Even though it appears to be gospel on this board, don't let anyone convince that correlations don't change over time or that correlations are increasing between US & Int'l markets and their justifications for why that is so. You can check portfolio visualizer yourself and see that the correlations between US & Int'l markets has fallen since 2011. Will it continue? I have no idea. But I also don't give up on diversifiers just because they don't always work. YMMV.
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asset_chaos
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Re: Diversification Benefit of a specific asset class

Post by asset_chaos »

I think looking at correlations to other individual funds isn't the right approach. What you want is to calculate a Sharpe ratio for your entire portfolio with and without the asset class in question and see if it's improving the portfolio level risk-return characteristics. I don't know if portfolio visualizer or some other web tool will do that calculation. More precisely, if you can do the Sharpe ratio comparisons, there's still a hidden second decision to make. This calculation tells you how your portfolio would have improved over the past period for which there is data. Then you have to decide if the result is likely enough to persist into the future time period over which you're actually investing. I think the OP's is an interesting question to ask, but I'm not sure how much accuracy to ascribe to even a good answer.
Regards, | | Guy
Northern Flicker
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Re: Diversification Benefit of a specific asset class

Post by Northern Flicker »

Asset correlations for the specified tickers
Ticker VNQI VNQ VBMFX VIG VSCPX VWO VEA
VNQI - 0.32 -0.09 0.17 0.38 0.82 0.68
VNQ 0.32 - 0.62 -0.09 -0.14 0.40 -0.24
These are just historical sample correlations from some arbitrary time period, not correlations calculated from the joint probability distributions of future returns, which are unknown, and what determines the risk mitigation of the diversification.
Risk is not a guarantor of return.
Northern Flicker
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Re: Diversification Benefit of a specific asset class

Post by Northern Flicker »

I think looking at correlations to other individual funds isn't the right approach. What you want is to calculate a Sharpe ratio for your entire portfolio with and without the asset class in question and see if it's improving the portfolio level risk-return characteristics.
Sharpe ratio over what historical sample? It will be very difficult at best to do this in a manner that generalizes to future returns.
Risk is not a guarantor of return.
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asset_chaos
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Re: Diversification Benefit of a specific asset class

Post by asset_chaos »

jalbert wrote:
I think looking at correlations to other individual funds isn't the right approach. What you want is to calculate a Sharpe ratio for your entire portfolio with and without the asset class in question and see if it's improving the portfolio level risk-return characteristics.
Sharpe ratio over what historical sample? It will be very difficult at best to do this in a manner that generalizes to future returns.
Yes, hence the rest of my post.
Regards, | | Guy
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