{"id":20431442,"date":"2020-11-29T06:30:54","date_gmt":"2020-11-29T06:30:54","guid":{"rendered":"https:\/\/stockviz.biz\/index.php\/2020\/11\/29\/volatility-and-allocation\/"},"modified":"2021-09-14T12:58:59","modified_gmt":"2021-09-14T07:28:59","slug":"volatility-and-allocation","status":"publish","type":"post","link":"https:\/\/stockviz.biz\/index.php\/2020\/11\/29\/volatility-and-allocation\/","title":{"rendered":"Volatility and Allocation"},"content":{"rendered":"\n

Think in terms of volatility buckets, not assets<\/h2>\n\n\n\n

This post is part of our series on diversification and asset allocation. Previously:<\/p>\n\n\n\n

  1. Diversification and its Malcontents<\/a><\/p><\/li>

  2. The Permanent Portfolio<\/a><\/p><\/li>

  3. Sequence Risk and Asset Allocation<\/a><\/p><\/li>

  4. Static vs. Tactical Allocation<\/a><\/p><\/li>

  5. Tactical Allocation<\/a><\/p><\/li><\/ol>\n\n\n\n

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    The thrust of our previous posts on allocation was that Indian investors shouldn\u2019t blindly copy strategies that worked well in the US. There are a lot of qualitative arguments to be made to support a India-dominant view for allocation strategies. In this post, we introduce a quantitative aspect to the discussion.<\/p>\n\n\n\n

    It is Volatility, Stupid!<\/h3>\n\n\n\n

    In finance, more than any other field, it is very easy to get correlation and causation mixed up. <\/p>\n\n\n\n

    A man goes to the doctor and says, “Doctor, wherever I touch, it hurts.”
    The doctor asks, “What do you mean?”
    The man says, “When I touch my shoulder, it really hurts. When I touch my knee – OUCH! When I touch my forehead, it really, really hurts.”
    The doctor says, “I know what’s wrong with you. You’ve broken your finger!” <\/p><\/blockquote>\n\n\n\n

    There are no universal laws for an asset class that holds across geographies and economic systems. The reason why a 60\/40 Portfolio \u201cworks\u201d in the US has more to with the quantitative aspects of the assets being mixed than what they are called. US bonds have benefitted greatly from a 30 year slide in yields, benign inflation and a flight-to-safety bid. None of these hold true for Indian bonds. So, expecting a 60\/40 Indian portfolio to behave like a 60\/40 US portfolio just because you mixed the same assets together is idiotic.<\/p>\n\n\n\n

    The most import aspect while considering assets for diversification are their volatilities. Specifically, the correlation of their volatilities at their left tails.<\/p>\n\n\n\n

    To keep things simple, consider a 2 asset portfolio: Eq and X. Eq has some average return that will be held constant during this analysis. What changes is its standard deviation (aka, volatility.) X is a stable asset with zero volatility (think of it as a fixed deposit.) How does different allocations to Eq change portfolio returns and volatility?<\/p>\n\n\n\n

    \"\"\/<\/figure>\n\n\n\n

    1. Low volatility is supportive of higher allocations<\/p><\/li>

    2. Higher allocations to the higher volatility asset progressively reduces the predictability of portfolio returns<\/p><\/li><\/ol>\n\n\n\n

      Volatility is Volatile<\/h3>\n\n\n\n

      Asset return volatility is itself volatile.<\/p>\n\n\n\n

      \"\"\/<\/figure>\n\n\n\n

      The past performance of a diversified portfolio is based on the realized volatility of its components. However, volatility itself is unpredictable over long periods of time.<\/p>\n\n\n\n

      Take-away<\/h3>\n\n\n\n

      While considering assets to diversify into, look at the volatility of the asset rather than what it is called. <\/p>\n\n\n\n

      Don\u2019t expect the quantitative aspect of an asset class to transcend economic systems – different markets need different treatments.<\/p>\n\n\n\n

      All investing is forecasting. And all allocation is forecasting volatilities.<\/p>\n\n\n\n

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