Safeguard 8: Avoid an Advisor with a Lavish Lifestyle (2009-06-29)

Safeguard 8: Avoid an Advisor with a Lavish Lifestyle

(2009-06-29) by David John Marotta

There will always be swindlers masquerading as investment advisors. You can learn to recognize such people by their over-the-top lifestyle. Avoid them at all costs.

The differences between the manager of a Ponzi scheme and a model citizen are almost imperceptible, which is not surprising. Those who would perpetrate a Ponzi scheme are usually not the demons everyone makes them out to be. And they are obsessed with appearing successful.

This fixation on appearances, however, is the red flag. If you are the millionaire next door, you know that frugality is one of the marks of an effective financial advisor.

But you may have to train your eye to recognize an immoderate lifestyle. If someone in business is worth $300 an hour, some apparent extravagances may in reality be productivity gains.

For example, if you hire a chauffeur to drive you to and from work each day so you can be productive, society gains. If you hire a gardener so you can continue contributing in your area of expertise, society gains. And if you hire a butler or a chef, so long as you employ someone else for less than $300 an hour, society gains.

Productivity gains are not synonymous with a lavish lifestyle, and with some careful observation you can learn to discern the difference. Productivity gains are all about function, and if you discover them you will find out accidentally. In contrast, the whole purpose of an extravagant lifestyle is to be noticed.

Consider Bernie Madoff. He and his wife lived in a $7M penthouse apartment in New York City and a house worth $3 million in the Hamptons. They also owned a $9.3 million Palm Beach mansion. Plus they maintained a $1M million chalet and two boats on the French Riviera.

They spent an average of $100,000 monthly on the corporate credit card on chartered jets, limousines, top hotels, fine wines, world travel and shopping. When they drove themselves, they rode in style in a BMW and or one of two Mercedes. Madoff bought a vintage Aston-Martin for his brother as a company car. The couple owned a Steinway concert grand piano worth $39,000. Madoff purchased tickets at the Mets Citi Field at $40,000 a season.

Madoff was also a prominent philanthropist, but his interests were anything but altruistic. He started the Madoff Family Foundation and gave to charities, which in turn invited him to serve on their boards. Madoff then invited them to invest their endowments.

He and his wife also gave more than $200,000 to the Democratic Party. He gained high-level connections to those in Congress who write the laws and are supposed to provide regulatory oversight. Madoff was one of the first to exploit kickbacks for brokerage order flows. He argued they should remain legal and not alter the price that customers received. His connections prevailed.

The Madoffs themselves owned $62 million in securities and $45 million in municipal bonds. They loaned their sons $22 million and $9 million, respectively. Oddly enough, having siphoned billions, the couple only has a net worth of about $823 million.

Wealth is what you save, not what you spend. That's why an ostentatious and excessive lifestyle is a red flag for an investment advisor. The middle class buys liabilities like boats and cars. The rich buy investments. If Bernie Madoff had bought businesses and investments, he would be able to make restitution of those initial investments. He might even be able to pay a fraction of the gains he claimed to have.

We all wonder what happened to the $65 billion. Much of it was phantom gains, and a lot of it was simply spent a million here and a million there. Excessive spending is a warning sign that your advisor doesn't understand wealth building personally.

In April this year, the Securities and Exchange Commission (SEC) charged Shawn Merriman of Aurora, Colorado, of collecting $20 million in a Ponzi scheme "to support his lavish lifestyle." He lied to investors, reporting "impressive and consistent annual returns" as high as 20%.

Merriman was known for showcasing his high-end art collection. U.S. marshals seized hundreds of works of art including some by Rembrandt and Picasso from his sprawling three-story home. Also seized were a silver Aston Martin, 1932 and 1936 Auburns and a 1932 Ford Highboy.

This spring the SEC also filed charges against Pennsylvania advisor Tony Young for allegedly stealing $23 million from investors to "support a lavish lifestyle for his family, including payments for expenses related to horse ownership and racing, construction, boats, limousines, chartered aircraft and other luxuries." That lifestyle included an opulent vacation home in Palm Beach, Florida, near the Madoffs' vacation home. Young also lied to accountants who prepared statements and claimed his losses in 2008 were only 5.8%.

Ponzi schemes are often discovered after market downturns when investors make the mistake of fleeing to safety. They want to take their stellar returns and put the money someplace safe while the storm blows over, only to find that no money is really there.

Additionally, the news cycle runs in themes. After the Madoff scandal, every Ponzi scheme became national news. The theme, played over and over, is that all financial services, from Fannie Mae to AIG, are rife with corruption and mismanagement and need more government regulation.

But more control won't protect you from dishonesty. More law can't protect you from an unethical person. Fannie Mae and Freddie Mac had direct congressional oversight. Madoff was good friends with the regulators. Regulation is more likely to be used politically than responsibly.

Your best defense is to engage an advisor whose daily practices reflect ways to safeguard the money under his or her fiduciary care. As part of identifying such an advisor, make sure there is a mutual understanding that an ostentatious lifestyle is not a valid financial goal.

from http://www.emarotta.com/article.php?ID=343

Safeguard 7: Avoid Investment Advisors Who Sugarcoat Reality (2009-06-22)

Safeguard 7: Avoid Investment Advisors Who Sugarcoat Reality

(2009-06-22) by David John Marotta

We've already discussed the many ways you can safeguard your money. But these methods cannot protect you from an unscrupulous advisor. My brother, who is a lawyer, has a saying we must all take to heart: "You can't do a good deal with a bad person."

Morality can be described as a continuum from pure altruism to unadulterated self-centeredness. All advisors have their shortcomings, of course. But excellent advisors work hard to cultivate certain traits, and among them honesty is paramount. This quality in an advisor includes communicating clearly and straightforwardly exactly how bad the markets have been and can be.

Advisors naturally want to look good, and you must overcome your own desire to have a good-looking advisor. You need the truth. You can handle the truth, and without it, you certainly can't make realistic financial plans.

The markets are profitable. The markets are volatile. You can't pick just one. Even in our recent financial meltdown, I believe the wisdom of rebalancing back into fallen markets will be vindicated. But you still need to know the facts.

There are certain red flags to watch for with advisors, ways they may try to circumvent the tough honesty you need. I include both what conscientious advisors should do for their clients, as well as how financial salespeople hide their mistakes.

Ask your advisor to provide a return for your entire portfolio, not just the underlying investments. Reporting how each investment did doesn't show how you did. Your advisor can buy an investment at the very end of the quarter and then report it did well during the entire quarter. Or your advisor can sell investments that are not doing well toward the end of the quarter. These changes do nothing for you, but they help an advisor who doesn't report a return on your entire portfolio look successful.

Also, advisors should give you an accounting of your return net of all fees and expenses. Any fund expenses, fees, commissions or trading costs diminish the bottom line of the return. Only by receiving information at the portfolio level can you measure the net effect of every expense you were charged.

Always insist on a time-weighted return (TWR). Returns can also be dollar weighted, sometimes called an internal rate of return (IRR). Often the IRR looks better. It is possible for the TWR to be negative and the IRR to be positive.

A TWR removes the effects of cash flows, which allows you to judge how your advisor's underlying investment strategy performed. If your advisor reports both, that's fine. But he or she should include the TWR as well, which is considered the industry standard and allows you to compare apples with apples between two different strategies.

Returns should be reported consistently over standard and preestablished time periods. In addition to the quarter that just ended, our firm reports year-to-date, the past 18 months, and the returns gained since we began to track the portfolio. We chose 18 months because it is the shortest time period that is still long enough to discern significant market trends.

One year isn't long enough to eliminate market noise. We've considered adding three- and five-year returns, but whenever an advisor changes the time periods reported, it is cause for concern.

The bottom of the last market occurred in October 2002, so three-year returns started looking good in the fall of 2005 and five-year returns in the fall of 2007. The recent market downturn provides an opportunity to report these longer time periods without arousing suspicion that these intervals are being changed simply for window dressing.

Getting an accurate accounting of your portfolio's return shouldn't be optional. If your advisor can't supply it, perhaps it means they don't know themselves or don't consider it important to their recommendations. Unfortunately, many so-called advisors in the financial services world would prefer to focus instead on how their own fees and schedule of commissions are doing.

Even if you safeguarded your money in the many ways we have suggested, you should also insist on only entrusting your money to an advisor who regularly reports what total TWR, net of all fees and expenses, your investments have made for the quarter and for longer periods of time.

from http://www.emarotta.com/article.php?ID=342

Investment Strategies Part 4: Don't Rebalance at the Sector Level (2009-06-15) by David John Marotta

Investment Strategies Part 4: Don't Rebalance at the Sector Level

(2009-06-15) by David John Marotta

Rebalancing between asset classes boosts returns and decreases volatility. But setting your asset classes based on sectors of the economy is not an effective strategy.

You can rebalance your investment allocation at three levels: stocks and bonds, between asset classes and among subclasses. At the highest level, rebalancing between stocks and bonds reduces risk. Selling some of your stocks after the market has appreciated limits your portfolio’s volatility and locks in some of your gains.

Correlation between investment categories helps define asset classes and sort out which are merely subclasses. The lower the correlation, the greater the bonus you can gain by rebalancing regularly. Rebalancing between U.S. stocks, foreign stocks and natural resource stocks offers a significant bonus because these asset classes have the lowest correlation.

Smaller bonuses are available within each asset class for categories with a higher correlation. But the law of diminishing returns comes into play as the number of categories continues to double and the correlation between divided subcategories approaches 1 (one).

Some investors try to allocate and rebalance between sectors of the economy. For example, Dow Jones divides the economy into these 10 sectors: Financials, Consumer Services, Telecom, Industrials, Basic Materials, Consumer Goods, Utilities, Oil and Gas, Technology and Health Care.

I don't recommend rebalancing at this level. You cannot know what percentage to allocate to each category. Putting 10% in each sector doesn't make sense because the division is arbitrary. Dow Jones puts Oil and Gas together in one sector. If they had divided it into two sectors, it would not have justified twice the investments. Dow Jones divides the index one way, and the S&P 500 indexes another.

Additionally, some of these sectors represent a greater percentage of the economy. If you set your target percentages now, the economy will change and your targets will be out of date. Technology has grown significantly as a percentage of our economy. Investors who continually moved out of technology missed much of the best returns during the 1990s.

Ten sectors taken two at a time produces 47 different pairings, each with its own correlation and rebalancing bonus or penalty. I computed those statistics using annual returns from 1992 through 2008. Some pairings have a bonus, and some have a penalty. I don't recommend rebalancing at the sector level, but an analysis of which sectors offer a bonus and which cost a penalty can suggest some investment strategies.

Some have a high correlation and have little or no bonus, such as Consumer Goods and Financials. Consumer Services, Telecom and Technology are also all highly correlated.

Basic Materials and Oil and Gas are subcategories of the natural resources asset class and therefore highly correlated. Oddly enough, they have one of the largest rebalancing bonuses partly because they represent different natural resources that are subclasses of the natural resources asset class. This is also true because Oil has had its bubbles.

Categories with a higher average bonus for rebalancing include Financials, Telecom, Technology and Oil and Gas. These are all sectors that have expanded and then corrected sharply.

Rebalancing out of bubbles is always warranted and valuable. But of course recognizing them is challenging. The bonus for rebalancing out of technology is the smallest of these because the growth in technology was mostly a shift in the economy and only a bubble at the very end of that trend. Shifting out of technology early would have killed returns. Timing the shift perfectly would have been difficult.

Rebalancing in this case is a poorer version of tilting toward value. A better bonus would be gained simply by emphasizing those stocks with a low price-to-earnings (P/E) ratio. When stocks in a sector bubble, they often experience high P/E ratios because they represent a greater percentage of the S&P 500.

The markets are smarter than the experts. It is by definition that they know what market cap a given industry deserves. It may bubble in its growth getting there, but you only know the bubble is over after it bubbles.

Four sectors offer a large rebalancing penalty with each other. They are Industrials, Basic Materials, Consumer Goods and Services.

Sectors of the economy wax and wane with the business cycle. As a result, when stocks in one sector of the economy are performing poorly, they may continue that way for some time. This form of rebalancing will result in lower returns than if you just let the market cycle adjust your portfolio.

Business cycles vary in length. As a result, annual rebalancing will incur a large penalty when you move out of a sector that did well last year into a sector that will do poorly next year. The penalty appears to be the worst for sectors that peak and valley at similar times during the business cycle, such as Industrials and Basic Materials or Consumer Goods and Services.

In this case, intelligent rebalancing, which takes the business cycle into account and rotates which sectors you are emphasizing, would at least try to capture the bonus and avoid the penalty. Knowing where you are on the business cycle, however, is just as demanding as predicting which industry will have the highest return.

Utilities are the least highly correlated to other sectors. They are a defensive sector and often do better than other sectors when the market is dropping. A sector rotation strategy suggests overemphasizing utilities and underemphasizing stocks when P/E ratios are high.

Sectors of the economy grow or dwindle based on global macroeconomic trends. Over time, companies responding to market conditions increase the capitalization of those goods and services that society demands and decrease those that are phasing out of the economy.

In the beginning we were an agrarian society. Then the industrial revolution began in America and Great Britain. Now we have more of a service-based economy. Perhaps genetics will bring about a health-care boom in the near future.

The lifetime of my grandparents spanned the Wright Brothers to landing on the moon. Your grandchildren may choose a college major that hasn't even been invented yet.

Setting percentages of your portfolio at a level of the sector of the economy doesn't make sense. If you set those percentages today, based on current levels in the S&P 500, our economy may never again match those percentages. There is no reversion to the mean for sectors of the economy.

Setting investment percentages also doesn't allow you to make strategic investments in sectors that you expect to grow and outperform over the next three to five years.

Rebalancing at the capitalization level (large cap and small cap) makes sense because large- and small-cap companies will always exist. Small companies have a higher expected rate of return because it is easier to double the size of a small company than a large company.

Similarly, it makes sense to rebalance using investment style (value and growth) criteria because these are universal descriptions of stock types and not specific to industry. A company can move between value and growth based on its price. Overweighting value companies outperforms growth stocks because of the risk of a growth company faltering in its expansion and causing a serious price correction. Limiting your investment in such stocks slightly smooths and boosts your returns.

Although the markets as a whole often revert to profitability and growth, this isn't true of individual stocks or industries. Most of the dot-com stocks that bubbled at the beginning of 2000 will never regain their former glory. Buggy whip manufacturers are no longer ubiquitous.

A better strategy is to look for three- to five-year trends in the economy and simply overweight those that have the best chance of continuing to grow in importance. Such trends last long enough for investors to take advantage, assuming they are looking forward to what may do well and not backward to what has been recently bubbling. Two such industries I would expect to do well going forward are health care and technology.

The most critical expertise that an investment manager can provide is a good investment philosophy. Investment analytics give you the best chance of matching your specific financial goals with the diversified investment mix that is optimum to meet those goals.

from http://www.emarotta.com/article.php?ID=341

Investment Strategies Part 3: Rebalance Regularly Between Asset Classes and Subcategories (2009-06-08) by David John Marotta

Investment Strategies Part 3: Rebalance Regularly Between Asset Classes and Subcategories

(2009-06-08) by David John Marotta

The investment metric correlation helps you continually take your gains off the table for safe spending. And it helps you determine what constitutes an asset class and which subcategories to consider for further diversification. Once these categories are defined, correlation can also reveal how much of a bonus to expect from your returns when you rebalance between two categories.

In his 1996 article "The Rebalancing Bonus," William J. Bernstein presented a brilliant formula to approximate the extra return you can expect by rebalancing your portfolio regularly. We rarely focus on a formula in this column. But there is deep wisdom here, both for portfolio construction and for determining which categories are worth regular rebalancing. Here is the formula:

B_1,2 = P₁P₂{σ₁σ₂(1 - c) + (σ₁ - σ₂)² / 2}

Where B is the bonus, P is the percentage allocation, sigma (σ) is the standard deviation (SD) and c is the correlation between the two assets.

The implications of the formula are useful, even for average investors. We can learn six valuable lessons from Bernstein's model.

First, notice the approximate size of the rebalancing bonus. A 50-50 allocation between two investments with a 0.5 correlation where each investment has an SD of 20% might be typical for equity investments. Such a mix has a rebalancing bonus of 0.5%. We will use the formula to demonstrate ways to boost this bonus. Even a half percentage point is noteworthy.

Investment professionals divide an extra 1% into hundredths of a percent, called "basis points." Earning an extra 50 basis points is huge. Investment advisors bend over backward for an extra 10. So rebalancing pays.

Second, the rebalancing bonus is the sum of all possible rebalancing bonuses. Our example of a 50-50 allocation has a 0.5% bonus because there is only one potential allocation mix to rebalance. With three categories allocated 33-33-33, the bonus rises to 0.67%. Each of the three rebalancing opportunities contributes 0.22%. Four categories split 25-25-25-25 provide a 0.75% bonus by giving six smaller rebalancing opportunities. Five categories of 20% each give 10 separate pairs of rebalancing for a 0.80% bonus.

Investors are taught to minimize the number of investments and investment categories. Although there is a gradual law of diminishing returns, diversification provides investment gains any time the investment itself is worthwhile and the correlations are low. With computer support for the analysis and rebalancing, investors can handle a large number of categories and holdings.

Third, note that the rebalancing bonus is proportional to the product of the percentage allocated to each holding. With a 50-50 allocation, the product is at its maximum at 0.25. A 60-40 allocation is nearly as high at 0.24. With a 70-30 allocation, the product drops to 0.21. And 80-20 drops all the way to 0.16.

The bonus is at its maximum when roughly equal allocations are made to each asset category. The smallest allocation should be at least half the size of the larger allocations. Our example, with four equal holdings of 25-25-25-25, resulted in a 0.75% bonus. An allocation of 30-20-30-20 is still high with a 0.74% bonus. But a 40-10-40-10 allocation drops the bonus to 0.66%. And an allocation of 85-05-05-05 drops the bonus way down to 0.27%.

Thus when an option is investment worthy, it merits a significant allocation. A good rule of thumb is to only skew an investment choice as much as two thirds to one third. Always invest at least a third into the smaller allocation.

The remaining lessons come from the terms inside the curly brackets of the formula. The allocation product is multiplied by the sum of these two terms. Maximizing their sum augments the bonus gained from rebalancing. Either of these two terms might be zero under certain circumstances. Each term has lessons to teach the savvy investor.

The first term depends on the correlation between the two investments. That is, the lower the correlation, the higher the bonus. A correlation of 1 has no bonus. Our example had a correlation of 0.5 and a bonus of 0.5%. If the correlation drops to zero, the bonus doubles from 0.5% to a full percentage point. At negative 0.5, the bonus becomes a full percentage point and a half.

So lesson 4 teaches us that the lower the correlation between two investments, the greater the importance of rebalancing. Rebalancing at the asset class where correlation is the lowest is more consequential than rebalancing between suballocations with a higher correlation.

Fifth, we learn that the higher the volatility of the investments, the greater the bonus in actually rebalancing. In our original example, both investments had a SD of 20%. The higher each SD, the higher the rebalancing bonus. By raising the SD of both investments from 20% to 30%, the rebalancing bonus increases from 0.5% to 1.13%. At 40%, the bonus is 2%. At 50%, the bonus is 3.13%.

Emerging market investments are extremely volatile. When they appreciate, an excellent strategy is to trim the position and take some profits off the table. When it drops precipitously, it is equally critical to reallocate and invest some more. Volatility equals opportunity if you rebalance regularly.

The last term is the difference between the SDs. It was zero in our example because the SDs were both 20%. To consider the contribution to this term, take the case where one of our investments has a 20% SD. But the other investment is as secure as possible and has a SD of zero. The first term becomes zero, but the second term makes up the difference.

With half invested in stable investments, the rebalancing bonus when the other half has a SD of 20% again is 0.5%. As the equity investment becomes more volatile, the bonus increases. At 30% SD, the bonus is again 1.13%. At 40%, the bonus is 2%. And at 50%, it is 3.13%.

Thus the greater the difference between the SD of two investments, the greater the bonus from rebalancing. Moving money from bonds back into stocks after a market correction yields substantial gains. A recent study from Fidelity shows exactly that: "Millionaires who used past recessions as buying opportunities now boast an average of $1 million more in investable asset than millionaires who shifted into more conservative investments."

Finally, we must learn to recognize when rebalancing provides a good chance of boosting returns and when it is unimportant. Rebalancing between two categories of U.S. stocks with a 0.85 correlation only gains a 0.15% bonus. In contrast, rebalancing between fixed income and emerging markets gains nearly 1.5%.

I asked formula creator William Bernstein how he might caution investors. He answered, "Rebalancing works best with high-volatility, low-correlation assets with similar long-term returns. Although this usually boosts the return of the equity part of the portfolio, if the returns are different enough, as occurred with Japanese equity over the past two decades, it can actually reduce return. This is not a free lunch."

The markets are inherently volatile. Rebalancing works best for categories that qualify as asset classes or subclasses. Next week we explore which investment categories do not warrant rebalancing because you are more likely to reduce returns than boost them.

Rebalancing is always a contrarian move, selling what has done well and buying what has done poorly. Many investors don't have the discipline to take that step when it is appropriate. But regularly rebalancing your portfolio offers expected returns about a percentage point better than buy and hold. Rebalance your portfolio regularly, and take advantage of this bonus.

from http://www.emarotta.com/article.php?ID=340

Investment Strategies Part 2: Use Correlation to Define Asset Classes (2009-06-01) by David John Marotta

Investment Strategies Part 2: Use Correlation to Define Asset Classes

(2009-06-01) by David John Marotta

To boost returns and protect your investments, you can use the investment metric called correlation. It will rebalance your portfolio at three levels of investment allocation: stocks and bonds, asset classes and sectors of the economy. The dominant categories of stability and appreciation are the most basic way to view your portfolio. By continually trimming your stocks while the market appreciates, you can replenish the money that we hope you are setting aside regularly for safe spending.

Over a long enough time, an allocation to lower performing investments such as bonds generally results in a lower expected return. Thus asset allocation at this level helps control risk. It also provides enough allocation to stable investments to cover a period of safe withdrawal rates of five to seven years, so the appreciating assets have time to recover after a market correction.

Below the broadest categories of lower risk bonds and higher returning stocks are candidates for asset classes. Asset classes are used to set the percentage of your investments that you will put in each category. Each investment advisors may define their asset classes differently. But studies have shown that diversifying among categories with the lowest correlation produces the most return for the least risk. Therefore these categories represent the optimum candidates. As the correlation rises, assets are more apt to be classified as merely sectors or subsectors of the investment world, rather than asset classes.

Six-month correlations fluctuate over time. Many of the correlations between investments were near their lows in mid-2007. Throughout this article I cite correlations at these lows usually against the S&P 500. Recently, six-month correlations have been relatively high. A demand for dollars has caused all categories to move down in sync with one another.

The Natural Resources Index at 0.38 has one of the lowest correlations to the S&P 500. This index does not represent commodities but rather the companies that produce or provide them. For example, the index tracks oil and mining companies, not the price of oil or minerals.

Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver), and base metals such as copper and nickel. It also covers other resources like diamonds, coal, lumber and even water. Real estate is also included because land serves as the underlying hard asset. Having such a low correlation clearly shows these companies deserve their own asset class.

Many advisors don't have an asset class for natural resource stocks. Instead they select one portion of the category, typically real estate, and make that the asset class. This can also be a good idea. Real estate indexes have correlations as low as 0.49 against the S&P 500. We use real estate as a subclass within the natural resources category because at times it has a low correlation with energy and other commodity movements.

Not only do natural resource stocks have a low correlation to other U.S. stocks. They have an even lower correlation to U.S. bonds. Natural resources (commodities) often exhibit a negative correlation to fixed-income investments due to their inverse relationship to inflation. So their optimum allocation depends on both the amount you designate to stocks and the amount you designate to bonds.

The second best candidate for an asset class is foreign stocks. The correlation of the EAFE Foreign Index is 0.57. It hasn't always been that low. The correlation between U.S. stocks and foreign stocks fluctuates over time between 0.4 and 0.9. When the correlation is high, many advisors argue that no benefit will accrue from investing in foreign stocks. When the correlation is low, it is often because foreign stocks are doing better.

At the end of April 2009, for example, the EAFE index hadn't lost anything over the past 10 years. Compare that with the S&P 500's negative 2.48% annual return resulting in a 22.2% loss for a decade's worth of investing. At times little diversification may be realized by investing in foreign equities. But the benefits happen consistently enough for our firm to consider foreign stocks its own asset class.

Some people try to diversify internationally by investing in U.S. companies that gain a significant portion of their revenue from sales abroad. But studies have found that these multinational companies still track fairly closely with other domestic companies. And they don't offer the same benefits as investing in foreign stocks.

We use country selection and emerging markets as our subclass allocation. At 0.50, the Emerging Markets Index correlation to the S&P 500 is even lower than the EAFE. It has also has had some of the best returns, recently averaging 8.24% and totaling 120.7% over the past 10 years.

And these stellar returns include having lost 42.90% over the last year! Sometimes you have to make a large profit to still have decent returns after a market correction.

Because correlations fluctuate, defining what constitutes an asset class and what constitutes a subclass is subjective. It is always open to review and reevaluation. Generally, a correlation that can drop below 0.6 with other asset classes is a good candidate to become its own asset class. The correlation of around 0.85 between emerging markets and other foreign stocks suggests it should simply be a subclass of foreign stocks.

Within the asset class of U.S. stocks are also several subclasses that provide opportunities for diversification. The Russell 2000 small-cap index, for example, has a correlation of 0.75 against the S&P 500.

Using correlation to define our top-level asset categories, therefore, we use three asset classes for stability (short money, U.S. bonds and foreign bonds) and three for appreciation (U.S. stocks, foreign stocks and natural resource stocks). Then within each asset class, we suballocate for additional diversification.

Most investors and even many advisors use investment categories entirely contained within U.S. stocks and bonds. A low correlation investment strategy, in contrast, would suggest broadening your horizons to obtain the lower volatility offered with a broader definition of asset classes.

from http://www.emarotta.com/article.php?ID=339