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- Jun 25, 2005
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Here is a very recent paper by Carl Isrealsen "The Benefits of Low Correlation" which studies everal asset allocation models of a portfolio in withdrawal mode (i.e. a retiree's portfolio). If this study does not turn you into an asset allocator, I don't think anything will
Summary
There are several quantifiable benefits of lowering the correlation of a retirement-withdrawal-mode portfolio's component assets. First, there is a dramatic reduction in the volatility of the portfolio's performance (i.e., lower standard deviation of return). Second, there is a significant reduction in the worst-case portfolio loss, or maximum drawdown. Third, the likelihood (or frequency) of loss is minimized. Fourth, performance does not suffer if sufficient diversification is achieved.
This study suggests that maximum portfolio loss, frequency of loss and probability of recovery following a loss are quantifiable measures of the benefits of low correlation. Furthermore, this study suggests that these three measures may have greater intuitive appeal to investors than standard deviation of return.
As was shown by the mathematics of recovery for portfolios in withdrawal mode, avoiding large losses is of paramount importance. Achieving low correlation among the assets in a portfolio—the key to generating a multitude of benefits—requires the use of a variety of low-correlated assets. Some of the needed assets may not fit the standard paradigm of a traditional retirement portfolio, namely commodities and REITs.