Diverse portfolios ensure at least some investments will be in the capital market's top performing category at any given time, regardless of what's hot and what's a flop. And you will never be fully invested in the year's losers. Different securities tend to perform uniquely at any point of time and with a diverse mix of assets, a portfolio will be less likely to suffer extreme losses that would impact concentrated portfolios. At the most basic level it is simple practice of not putting all your eggs in one basket; yet, at the root of diversification is a concept called correlation, which is a measure of how the returns of investment asset classes move together. Studies suggest when you collect different assets that have low correlations in a portfolio, you may be able to get more return while taking on the same level of risk, or the same returns
In a recent post, I wrote that utilities-as an asset class-are not currently offering enough yield to justify their risk levels, although individual utilities may be worth considering. This begs the question as to which utilities look relatively more attractive than the sector as a whole and how we might determine this.
In my approach to designing income portfolios, I focus on two metrics: yield and risk. Yield is directly observable and risk is observable in hindsight but tends to have a high level of persistence. I am not going to go into depth here, but I have written a number of articles comparing historical risk levels, projected risk levels, and option implied volatility. They tend to be remarkably consistent. My approach to calculating a projected risk combines trailing risk for an asset-say the iShares U.S. Utility ETF (IDU)-with a model that adjusts this volatility based on the correlation
I just saw an analysis of how various asset classes performed during the four-month period after Ben Bernanke suggested that the time for the Fed to cut back on its bond purchasing program was approaching. The markets reacted dramatically -- what has been referred to as the 'taper tantrum.' The summary chart is shown below:
(click to enlarge)
Source: Brian Levitt, Oppenheimer Funds (article in Forbes)
This chart shows returns on various asset classes over the period from 5/2/2013 to 9/5/2013. The article notes that the yield on 10-year Treasury bonds rose 137 bps (1.37%) over this period. The results are dramatic for a number of reasons. First, of course, the relative gains and losses from various sectors or asset classes are huge. Telecom stock and utility stocks declined by 10.8% over four months. This is truly dramatic. On the other hand, it is the norm for utilities to