Retirement Asset Correlations
October 12, 2010 by MJP
Filed under Investing for Retirement
Asset correlation is a concept of critical importance to a retirement investors. I have spent a lot of my own time studying correlations as they pertain to our retirement portfolio. I have found a new online tool that makes this job easier. First, a brief refresher on the subject.
A correlation of 1.0 does not mean that two asset classes have the same volatility or that they will always change in value at the same rate. It means that the valuations always move in the same direction.
The concept of asset correlation is a core principle in modern portfolio theory. A portfolio that incorporates asset classes that are highly correlated may be too volatile for retirement because if the stock market falls, everything in your portfolio is likely to fall with it. This can also happen in a “black swan event” when economic conditions are so extreme (or sellers or so panicked) that everything falls together. (Hello 2008!)
The bottom line is that it is helpful if not essential for every retirement investor to have some understanding of how the assets in his or her portfolio are correlated. There is a new site Asset Correlations that will assist you in learning this.
The site home page presents a matrix of correlations between different asset classes and investment indexes. This provides excellent guidance on selection of general types of investments that are non-correlated (move independently). The matrix is also color-coded to indicate degrees of portfolio diversification.
I’m not sure I agree with a strong negative correlation as indicating “excellent diversity.” I’m more interested in having strong performing assets that are not correlated at all, i.e., a correlation coefficient near zero. Those are hard to find but you need at least some in your portfolio. One example shown in the matrix are TIPS which are generally non-correlated with all other asset classes excluding U.S. bonds. (Yet another reason to own them.)
An even better feature of the site is the ability to upload your own portfolio and generate a correlation matrix based on your holdings.
If you want to compare the “risk vs. return” characteristics of your portfolio with those of other users, you can do that as well by causing the site to generate a scatter graph.
There is also a tool allowing you to view the correlation of two specific investments over a specified time period.
You should definitely spend some time using these asset allocation tools with your own investments. Even if you are using a financial advisor, what you discover may give you some important questions to ask.
What do you think about the value of this asset allocation site to your retirement planning?
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I think a lot of this asset correlation theory is interesting and totally irrelevant. Buy real estate when it makes sense to do so. Leverage when leverage is positive and grow your portfolio. Let your tenants pay for the property and your retirement. Structure your portfolio at retirement to provide substantial tax shelter as well as predictable income. Along the way, peel off some of the cash flow and buy some quality dividend growth stocks and treasury bonds. Give Wall Street, Washington and your state capitol a raised middle finger salute as you fly off into the sunset on the first of many trips paid for with your cash flow.
It’s not irrelevant to people (like me) who have no interest in fooling around with whining tenants and endless property maintenance headaches, or to folks who understand that finding and owning “quality dividend growth stocks” or tax-sheltering income is no longer as easy as you make it sound.
But your recipe sounds good in theory and I’m sure it worked for you.
Property management and thoughtful property selection significantly reduce the landlord headaches. Sheltering income via real estate is very easy if you plan carefully and keep on eye on your depreciable basis.
I focus on stocks that consistently grow their dividends, have low payout ratios, and are conservatively managed businesses that keep the shareholders’ interests in mind. For a blog that intelligently discusses this approach, see
http://www.dividendgrowthinvestor.com/
For one knowledgeable advocate of investment real estate as the best way to create retirement income, check out
http://www.bawldguy.com/
Your way of doing things results in a decent amount of principal at retirement and near zero tax shelter of the distributions. I would be interested in your thoughts on their math, particularly with respect to the real estate.
My partner owns lots of rental property and has for many years. Unfortunately for him, now that he is close to retirement, he has used up a lot of his depreciation and is facing significant tax liabilities on his rental income. I don’t know what his actual ROE is but it has to be ridiculously low. The only way he can get his ROE up is to to refinance and use leverage to buy more property but who wants to take on that kind of risk late in life? The tax hits will be even greater when he has to sell them with a zero basis, with capital gains rates destined to go up. Plus, his wife works full time managing the properties, even though they employ a full-time maintenance man. Who wants to do that? Not me.
I used to be a big-time dividend investor. Many banks met all the criteria you described until 2008 happened and the dividend cuts began. It’s a nice theory that dividends will last forever but reality intervenes.
Having some non-correlated assets in a retirement (or any) portfolio is generally a good idea. During the market decline of ’08-’09 many asset classes that were thought to have low correlations to each other saw their correlations run closer to one. Modern portfolio theory was thought by many to be a failure.
Modern Portfolio Theory is a tool, nothing more, nothing less. No investor or advisor in my opinion should base the construction of a portfolio soley based on the outputs of MPT. However the concept of asset correlation is ignored at one’s peril. What needs to be considered, however, is that relative correlations do change over time. If the goal is to have a portion of the portfolio contain non or low correlating assets, the allocations to and/or choices of non-correlating assets may have to be adjusted over time.