Risk and High Correlation
Why The Absolute Approach Works.
What our research has found is that the most common method of allocating assets over the past few decades offers little diversification benefits to investors and in most cases exposes them to directional market risk that is under appreciated by many professionals and individuals. Moreover, investors take on too much risk.
We have created a helpful heat map of typical investment asset classes. The scale below shows that highly correlated assets in red (move together), inverse correlated assets in green (move opposite) and non-correlated assets in blue (move independently). Ideally one would want as many non or extremely low correlated assets in a portfolio as their performance, good and bad, is independent of the others.
Step 1: True Diversification comes from non-correlated assets and strategies: This is where we start.
Step 2: We rank each candidate by a Three Step Quantitative approach:
Step 3: Overall Trend
In order for an investment to be included in our index it's price must be above trend.
Step 4: Revisit and Re-balance Often
The world we live in changes constantly. Having an approach to hold an investment for years flies in the face of common sense and sound risk management principles. Our indexes are re-balanced at least monthly.
Below is a correlation study of the most common allocation of equities in a traditional portfolio. As you can plainly see the correlation between theses various stock groupings is high.
In order to achieve greater diversification as ascribed by Modern Portfolio Theory, PCM has developed a mix of non or low correlated strategies that can be used individually in an portfolio or combined to decrease directional market risk. A strategy is nothing more than an approach of buying and selling any investment. Buying a stock or traditional mutual fund is a strategy where gains are made when the price increases and losses occur when the price decreases relative to ones purchase price. If you are an investor, you are using a strategy whether you know it or not. Buying growth stocks, international ETFs, or value stocks is a strategy. Buying bonds is a strategy. How you execute the strategy is a separate topic in and of itself.
Below is a heat map of Provident Capital's Absolute Indexes. Take note the the overall correlation between the various indexes is low. Much lower than the traditional approach above even though the indexes use many if not all of the traditional indexes above. This is where the philosophy and execution of a strategy make a difference.
What's Working Short Term:
What's Working Intermediate Term:
Volatility: There is a direct correlation to high volatility and subsequent drawdown. In order to minimize the potential risk Provident's quantitative analysis screens out investments that demonstrate higher volatility.