Consider this figure:

Correlations among global securities

The first 14 securities are indexes and ETFs of various segments of the USA equity market. These are followed by a European and a Chinese equity ETF. The last  five are currency, fixed income or anti-inflation securities.

Note how the equity indexes are very highly correlated with each other (with most correlations over 0.8 and thus green in the matrix), but very uncorelated with the non-equity securities. GLD, the gold ETF, is truly uncorrelated with both equity and the 30 year T-Bond ^TYX.  Interestingly, GLD  and TIP (the anti-inflation US treasury security) are moderately correlated at 0.4. We would expect this since they both are used to protect against inflation, but are not equivalent in their structure.

The two rows above the matrix show the returns and volatility of each security. Note that the highest volatility is for VGK (41%/yr) and the lowest is for TIP at 5%/YR. On the other hand, only 7 of 21 securities measured have positive returns for the last 45 days. The highest return was China (FXI at 50%/YR) and the lowest was Dow Jones US Industrials (IYJ at -38%/YR).

We say this matrix, derived from the last 45 days of price action, indicates securities can best be picked based upon estimates of returns, assuming most securities will continue their very high correlations. Only asset classes, broadly categorized as equity/fixed income/anti-inflation, have negative or zero correlations for diversification.

Thus, we see yet again how the asset allocation task requires the asset class be picked before individual securities.

Budgeting skills are as important as what your portfolio is doing—probably, more important really, because budgeting is an everyday issue. If a person can scale back appropriately so that they can actually survive on a 4 percent withdrawal rate, they’re good. Any reasonably designed retirement portfolio will last with a 4 percent withdrawal rate. Eight percent? You’re going to have to get really lucky in your investments.

We love reading his work and he’s a very sharp, knowledgeable finance maven. But his claim about the 4 percent withdrawal rate seems a tad glib–there are many assumptions built-in to this claim that need explanation. Would you really like to bet on such a simple number for your retirement? We think not.

Intuitively, at 4% withdrawal rate,  if your return is 4%/YR and inflation is nil, then in fact you can simply withdraw the gain each year and never deplete the principal. But if, for example, inflation is 2%/YR and your return is 4%/YR, then we can show 4% withdrawal rate would last you 34 years. Not bad. But if your return is 3%/YR and inflation is 4%/YR, then this account will deplete after 22 years if withdrawals are at 4%/YR.  That’s probably a big difference. We show you how to handle all these “What Ifs”.

This post introduces the idea of the Safe Withdrawal Rate (SWR), a concept that has recently captured the attention of many investment advisors and publications. We introduce our own focus on this topic now. We announce two initiatives. First, we published a descriptive piece in Advisor Perspectives, a highly respected and popular website for investment professionals. This piece explains SWR ideas without math for the average investor. Second, we published our full research results in detail here, in our permanent pages (see Investing Tools drop-menu above, or click this link):

Investing Tools> Safe Withdrawal Rate

This page introduces our technical analysis and methodology to determinine your own, personal SWR. Our innovation: we capture each individual’s beliefs about his own future returns and inflation to find the expected value of his SWR, irrespective of market history. Ultimately, your personal beliefs about how future returns and inflation evolve is all that matters for your planning purposes.

Today, Bloomberg News makes a very strong and creatively presented case for deflation. We now have some serious validation….but no joy.

As the magazine says in the article:

In selecting this year’s winners, Global Finance’s editorial team considered objective and subjective factors. Objective criteria included growth in assets, profitability, geographic reach, strategic relationships, new business development and product innovation. Subjective criteria included the opinions of equity and credit-rating analysts, banking consultants and others in the industry, as well as corporate financial executives. The winners are not always the biggest banks but, rather, the best banks – those with the qualities that corporations should look for when choosing a ban

You can read the article and the winners  here.

The new assumptions present a far different picture of risk. Consider the 60% stock, 40% bond portfolio that fell about 20% last year. Under the fat-tailed distribution now used in Ibbotson’s tool, that should occur once every 40 years, not once every 111 years as assumed under a bell-curve-type distribution. (The last year as bad as 2008 was 1931.)

Insulation from extreme market events doesn’t come cheap. Allianz SE’s Pacific Investment Management Co., or Pimco, which systematically hedges against extreme market events in several mutual funds launched last year, says the hedges may cost investors 0.5% to 1% of fund assets a year. Pimco uses a variety of derivatives and other strategies to hedge the funds.

You can read the whole article here: ( “Some Funds Stop Grading on the Curve”, 8 SEPT 09 ).

In many ways, this new approach to portfolio optimization incorporates the barkings of Nassim Taleb, of Black Swan fame, who has been incessantly warning of the dangers of designing portfolios assuming the “thin” tails of the Gaussian probability density, rather than using a more realistic “fat tail” model. Fat tails more accurately, and usefully, account for extreme bad outcomes, such as we recently experienced in the credit and real estate markets.

We expect in one to two years the large investment and broker-dealer firms will routinely offer Fat Tail-based portfolio design as well as special mutual funds incorporating these ideas.

Finally,  as we noted in our post of 15 JULY 09, this knowledge has been available for 20 years. So it is quite stunning that the financial industry, which usually is amazingly fast to adopt good ideas, has avoided the fat tail approach until now.