Portfolio Diversification X-Ray
As explained in the article “Is Your Portfolio Really Diversified?”, we need to invest in uncorrelated securities to ensure portfolio diversification. We also showed how, given a matrix of security-return cross-correlations, we calculate the Portfolio Diversification X-Ray (PDX). The PDX measures the degree of diversification among those securities. But how can we pick a good set of candidates to score with the PDX in the first place? We begin by casting a wide net around asset classes that seem pertinent to our beliefs about our investment world.
To exemplify a search, we have prepared a cross-correlation matrix of 21 securities. These securities were selected to be responsive to the New World Order of our economy, which seems likely to exhibit deflationary efects and then, with all the government money printed to avoid deflation, become inflationary as the massive extra money washes over the economy. The assets are represented either by indexes or ETFs drawn from a variety of assets, and from narrowly chosen individual corporate stocks. We inspect the matrix to see which, if any, pairs of asset classes are uncorrelated. From this observation, we can identify some sectors to examine in more detail.
For example, a 21-security cross-correlation matrix and its PDX are shown below (click to enlarge):
The matrix shows cross-correlations of daily asset returns for the 45 business days ending on 13 MAR 09. Obviously, correlations will change over time, so the set of assets, the matrix and PDX will be updated frequently with new matrices posted and discussed.