Thursday, January 18, 2007

Asset Allocation: How diversification improves portfolio performance

I'm reading Rick Ferri's All About Asset Allocation. Great book. More how to and less academic than Bernstein's book. I recommend reading the Four Pillars first. It has a stronger theoretical foundation.

In chapter 2 Ferri discusses risk and return. One of the interesting points he raises - something I hadn't read before, is the relationship between volatility, simple average return and compound return.

Volatility represents the amount of up and down an asset class experiences; e.g. historically, in one year, 86% of the time (i.e. usually) the asset class goes up to 20% or down to 7%.

The simple average return is the average of returns for each year; e.g. over 5 years the average return for each year was 10%.

The compound return is different. It factors the impact of the prior year's return into the results of the current year. So a highly volative stock might drop 20% in year one from 10 down to 8. The following year it goes up 10%. The new value is 8 times 10% or $8.80. Whereas the simple average would have calculated the value as $9.00. Over time, the numbers can drift apart quite a bit.

An effective asset allocation plan which invests in low correlating assets helps insure that only some assets go down, while others go up. The end result of an effective allocation strategy is reduced volatility while maintaining a high average rate of return.

As I read on, I'll share some of the thoughts I learned. I for one, am interested in the question "how do you allocate to reduce volatility while maintaining a high rate of return."


No comments: