Saturday, November 13, 2010

Asset Allocation: The Importance of Getting the Correlations Right

We just wrote a larger piece for the introductory issue of a new UK journal on Asset Allocation. More about the journal in a future contribution to this blog.

But we felt that we should share our piece on Asset Allocation and the importance of getting the correlations right with you.

Bottom-line: a lot of the mistakes people make with asset allocation are related to naive, simplified assumptions about correlation coefficients between various markets and asset classes. Way too often people use long-term historical averages whereas true correlations seem to differ in periods of high versus low volatility on the one hand, with patterns over time making in in general also much better to use time-weighted correlation estimates.

Empirical research indicates that proper incorporation of correlation coefficients might improve annual returns by 0.5-1.5 percent without increased risk. On the contrary: portfolio risk might even seem to go down as well!

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