False diversification and the U.S. world position

[lehighguy]

The idea is that if you hold multiple assets they will coutnerbalance eachother and make your variance lower. Take US stocks and oil. If oil is expensive then the US economy does worse. SO if you own oil futures and US stocks it will help counter balance eachother.

Here is a simple diversification method.

30% US, 20% Europe, 15% Japan, 20% China (my personal bias), 15% Emerging Markets

This will neutralize currency risk a great deal. Now try to hold a mix of stocks, bonds, and commodities.

Stocks: 1/3 Large Cap (big companies), 1/3 Medium Cap, 1/3 Small Cap. Use index funds (not mutual funds, low fee index funds: www.etfconnect.com).

Bonds: Try to pick bonds paying high interest rates, especially in countries that are expected to lower rates in the future. Good example: United Kingdom, Australia, China (maybe). Bad example: USA, Japan.
Note: You can't really buy bonds as a small investor, you need to buy bond funds (www.etfconnect.com - and other sources).

Commodities:
Oil, metals + materials(Aluminum, iron ore, etc). The stuff we need just to live. There are one billion + ppl in CHina that will want this stuff over the next 20 years, and they'll be willing to pay. Moreover, commodity prices and stocks are not very correlated so its a good diversifier.

You can do this all yourself with research which is good because you can avoid alot of the fees an advisor would charge you. Just be careful with more complicated things like commodities. I think there are commodity funds out there (GOldmen Sachs has one?).

[adios]

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The idea is that if you hold multiple assets they will coutnerbalance eachother and make your variance lower.

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Thank you very much for your response. Perhaps I didn't make myself clear though. I'm not quibbling with the idea that their are advantages to diversification including those that you mention. My question was how does one determine the proportion of one's available capital to allocate to each asset class. You've provided some percentages. Perhaps a better question is how did you arrive at those percentages and why do you feel that these percentage allocations offer correct diversification?

[lehighguy]

As for where I got them, well experience. I work in this industry, they are based on my opinion. I'm dollar bearish, but also realize that Europe and Japan have slow economies. I'm pretty bearish in general lately, I thought the market would have a post bubble run up, but it seems like thats out of steam.

As for correlations here's a rule of thumb:
The fed lowers rates when economy is doing bad (stocks doing bad), and bonds do well in falling rate enviorment. Vice versa is true for rising rate enviorment. Example of this would be the last 4 years.
COnclusion: Bonds up, stocks down. Stocks up, bonds down.

Commodities:
Oil and raw materials cost up, US stocks down. and vice versa.

Currency:
Dollar up, foriegn stocks down, dollar down foriegn stocks up.

[adios]

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As for where I got them, well experience. I work in this industry, they are based on my opinion.

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No offense but I find this less than compelling. Opinions are easy to come by [img]/images/graemlins/smile.gif[/img]. I suspect that the original post was more or less an opinion as well. If my portfolio is "falsely diversified" to me it means that the my expected returns are not sufficient given the risk I'm taking. Put another way, there is at least one alternative portfolio that I could construct where I take an equivalent amount of risk but my expected returns are higher. I'm going to make a post on this subject soon since this topic of proper diversification across asset classes has come up before. If I want to constuct a "truely diversified" portfolio of U.S. traded stocks that isn't too hard to do given the CAPM and it's implications. Dan's post alluded to the constuction of Markowitz portfolios to acheive "true diversification" but the CAPM more or less made constructing Markowitz portfolios unnecessary. Stay tuned for a post or two on this subject soon.

[eobmtns]

OK, this is what we know.

There is a record US deficit and Greenspan et al. may decide to sharply increase interest rates.

Or, the value of the dollar will go in the dumper (as Warren Buffett predicts).

Or both.

And, China is likely to float the yuan within 6 months resulting in its being sharply revalued against the $ and other currencies.

Iraq's Jan 30 election is likely to be accompanied by turmoil and who knows what military action the US might take against Iran, etc.

What stocks/sectors to buy/short? Higher interest rates? Short/put homebuilders/mortgage bankers?

Lower $? Buy/call Gold/mining/oil stocks?

Higher Yuan? Chinese stocks?

[lehighguy]

I could run some statistical tests and show you that would work pretty well. You do them in undergraduate finance classes. But if you don't want to here it that's ok too.

[laserboy]

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Commodities:
Oil, metals + materials(Aluminum, iron ore, etc). The stuff we need just to live. There are one billion + ppl in CHina that will want this stuff over the next 20 years, and they'll be willing to pay. Moreover, commodity prices and stocks are not very correlated so its a good diversifier.

You can do this all yourself with research which is good because you can avoid alot of the fees an advisor would charge you. Just be careful with more complicated things like commodities. I think there are commodity funds out there (GOldmen Sachs has one?).

[/ QUOTE ]

Goldman Sachs publishes one of several tracked commodity indices. A number of financial products have sprung up that aim to model the returns of these indices, the most popular of which are collateralized commodity future funds which buy leveraged commodity futures and invest the collateral in treasuries/high quality bonds. The indices vary dramatically in composition (the Goldman index is 65% hydrocarbons, fox example) and the funds vary in expense fees and indexing strategies. I am partial to PCRDX which tracks the Dow Jones-AIG index and invests the collateral in TIPs.

Regarding diversification, recent studies have confirmed the obvious... that commodities are negatively correlated with the stock market. What is surprising is how competitive their returns are and the degree to which they reduce "risk" in one's portfolio. A portfolio consisting of 60% US stocks and 40% commodities would have generated the same returns as an all stock portfolio with 1/3 the volatility, making commodities a great diversification tool for financial planners (Given current macro trends, I personally would pass entirely on holding US stocks). Check out "Facts and Fantasies about Commodity Futures" published by the Yale International Center for Finance.

[laserboy]

It all depends on your investment horizon. In the short term, anything can happen. Marc Faber and Jim Rogers are the most hardcore China bulls out there and they are both predicting "hard landings" for the Chinese economy in the near future. In the long term, I don't think there is any doubt that China is a country on the rise and that the US is a country in decline.

CHINA = PUMPING OUT 250,000 SCIENTISTS AND ENGINEERS A YEAR

US = PUMPING OUT MORE LAWYERS AND MBA'S THAN THERE ARE CURRENTLY IN EMPLOYMENT

CHINA = MAPPING THE RICE GENOME AND DEVELOPING CLEANER MORE EFFICIENT FORMS OF NUCLEAR ENERGY

US = AN ENTIRE ECONOMY BASED ON FLIPPING REAL ESTATE

[lehighguy]

I too am bearish China in the short run. They have had a good run, but an economy based largely off export growth to a country that can't take in any more exports just isn't a very sound model. Not to mention many of the same problems that plauged the system during the hardcore communist years are still there despite the reforms. And the fact that high commodity prices hurt them even more. And the fact that the government is actively trying to slow down the economy right now.

There are other things I could mention, but the more interesting picture for China is the long term. You really hit the major reason why China will do so well going foward

Quote:
CHINA = PUMPING OUT 250,000 SCIENTISTS AND ENGINEERS A YEAR

US = PUMPING OUT MORE LAWYERS AND MBA'S THAN THERE ARE CURRENTLY IN EMPLOYMENT

People in the US have become decadent and lazy. They don't want to learn math or science or anything that is "hard". Even the few engineers we have are all immigrants from Asia and India. And our education system is atrocious (college is good but pre-college is the worst). This is the major reason the Asian economies will do so well going foward. A weaker dollar will never solve the fact that we aren't training people for the technological jobs of tommorrow, so we won't be able to compete.

[RunDownHouse]

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People in the US have become decadent and lazy. They don't want to learn math or science or anything that is "hard". Even the few engineers we have are all immigrants from Asia and India. And our education system is atrocious (college is good but pre-college is the worst). This is the major reason the Asian economies will do so well going foward. A weaker dollar will never solve the fact that we aren't training people for the technological jobs of tommorrow, so we won't be able to compete.

[/ QUOTE ]
Go back to when the US was an industrial economy. Then picture someone saying that because nobody wanted to work in factories anymore, the US economy would go in the tank. Or picture someone saying, when the US was an agricultural economy, that since nobody wanted to work on farms anymore, we wouldn't be able to compete in the future.

What makes you think that the situation is any different now?