[MUSIC] Correlation and asset allocation. Not all assets or securities are affected by positive or negative shocks equally and here in lies the trick of asset allocation. An ideal asset mix would, in theory, be immune to shocks. Of course, this is impossible and it's impossible to mitigate all types of risk. But naive diversification is far superior to no diversification. Diversifying into the same asset class, choosing a narrow segment of the market to invest in, accumulating highly correlated assets in one's portfolio, all of these will undo any good diversification that you might already have in the portfolio. Here's a graph that shows you the correlation characteristics of the major asset classes. You can see some are highly correlated and some are lowly correlated. The trick in asset allegation is to put together highly correlated assets with lowly correlated assets to smooth out returns so that portfolio shocks will not impede the growth of capital. If you can find two asset classes with correlations close to zero, the diversification effects. Let's just pause for a second. The closer the correlation to zero is among the different asset classes, the better the diversity created effects. Typically, once your risk return profile has been established, capital is then allocated to various asset classes to achieve the maximum expected returns for a given level of risk. The incorrect weighing into an asset class can result in portfolios with undesirable risk return profiles. Along with the weightages, it is also crucial to be aware of the asset class correlations as in the table above by creating a mix. It is never prudent to put assets with high positive or negative correlations together in a portfolio. Positive correlations amplify external shocks, while the latter would serve to offset any gains with losses from the negatively correlated assets. There's an art here. Let's now discuss some of the pitfalls of modern portfolio theory and the effect of behavioral economics in the context of asset allocation. The crisis of 2007, 2008, brought forth many critics of modern portfolio theory. After all, modern portfolio theory measures risks in terms of standard deviation, and assumes that investors are rational. MPT, modern portfolio theory, states that one should ideally diversify into uncorrelated assets. But in reality, many asset classes become correlated in times of crises. Secondly, what has happened as globalization tends to connect the world much closer together, correlations within the asset classes have been rising over the years. This is especially true of equities. Global connectivity has made sure that information gets transmitted to various markets almost immediately and diversification benefits have now been reduced in equities. External shocks are also transported very quickly. What you can see in this chart below is that correlations among asset classes can be very high and this is particularly exacerbated during crises. So, rising correlations have affected the real world implementations of modern portfolio theory. Another critique of modern portfolio theory, which comes out primarily from the behavioral economists, is that the measure of risk in constructing these portfolios is standard deviation. Standard deviation has a very symmetrical view of risk because by definition it measures both upside volatility and downside volatility. But the reality is that investors are far more risk averse towards the downside. Draw downs is what they really get worried about, and don't really care about the upside. As the behavioral economists have found, investors are loss averse, that is they worry about the downside. Investors show risk seeking behavior in the loss domain and risk averse behavior in the profit domain. What they typically do is tend to book profits from winners while they gamble with losers. These realities need to be considered by asset allocations while making asset allocation decisions for retail investors. Because the goal of a good asset allocation is to have a portfolio that investors can stick through in good times and bad. And severe draw downs impair the ability of a lot of people, but particularly in retail, to stick to a disciplined asset allocation. Now retail funds have got to worry not only about the asset allocation that they engage in, they've got go worry about the clients who invest in their funds, and how they will deal with draw downs. Events in some far corner of the world, Can have domino effects in the country that the fund manager operates. I want to come to another important point in the practice of asset allocation, the need for rebalancing. The asset allocation decision is not a one-time exercise. Rather, it is a dynamic process. Over time, markets change, risk premium changes and so do the risk appetites of investors. Our ancestors were generally more risk averse than we are. Return characteristics of assets might change through economic shocks and even financial goals might change. Hence, it is prudent on the part of the investor to reevaluate the allocations in that portfolio. If the portfolio has deviated from the stated part or some change has to be made, then they should be updated as new information comes in. This may include the removal of certain asset classes, for example, illiquid securities. It may involve changing the weights of the asset classes, or it may, in fact, allow for the addition of new asset classes. Furthermore, the investor should take into account the fees that he's being charged by the person who creates his asset allocation. To conclude, asset allocation exercises in the 90s primarily consisted of allocating capital to a handful of stocks and bonds with some allocation to cash. But in the years since then, it has become more complex and nuanced. Asset class diversification is more common now, but looking through to the factors is also exceedingly important, as you don't want portfolios that are concentrated with respect to factor exposures. What do I mean by factor exposures? Private equity and public equity are both exposed to equities, even though they're two completely different asset classes with very different investor profiles. But they're both concentrated in exposure to one factor. These need to be put together in a disciplined way. To conclude, there are elements of science with numbers but also there is an art in putting together a good asset allocation and there are many nuances involved. This graph here demonstrates asset allocation in the past and asset allocation more common now. We will explore some of these new answers further in the next few classes. [MUSIC]
