With regard to selecting the optimal corridor, the text says:
“When asset class returns tend to move together, the impact of deviations from target allocations on portfolio risk are less. Higher correlations, therefore, suggest wider optimal corridors”
Not sure I follow. I tend to think of higher correlation as a negative and more risky, which is why you want less correlation between assets. This sounds like higher correlation has less of an impact. What am I missing???
Thanks in advance!
This is a tricky concept. While risk is higher, when it comes to rebalancing, the books says that since all assets are moving together, their is less risk for the asset allocation as a percentage to deviate from what investors choose it to be. Thus risk tolerence is higher and a wider corridor is called for.
So essentially, the target weights/allocations stay roughly the same since everything is moving together ? As a result, there is less deviation from the target weights and thus you can have a wider corridor before rebalancing?
Thanks Zanalyst! Not sure I’m completely understanding of the points on volatility either.
That is correct.
Higher volatility means higher risk. Which translates into a narrower corridor. Think of it this way, if assets are highly volatile in either direction, we would want a narrower corridor to stop our asset allocation from deviating too much at any given moment.
Suppose that your target SAA is 60% equity, 40% fixed income, with ±5% rebalancing bands. So you buy a $60 stock and a $40 bond. (You’re not a high net worth investor . . . yet!)
If the equity return is +10% and the fixed income return is +5%, then after a year you have $66 in equity and $42 in fixed income: 61.1% equity, 38.9% fixed income, which isn’t very far from your target SAA: ±1.1%. You won’t have to rebalance for about 4½ years.
If the equity return is -10% and the fixed income return is +5%, then after a year you have $54 in equity and $42 in fixed income: 56.3% equity, 43.7% fixed income, which it farther from your target SAA: ±3.7%. You’ll have to rebalance before the end of year 2.
Where did you get the SAA number sin your example, S2000? Zanalyst, thank you for you help!
I pulled them out of my . . . top hat.
The particular numbers aren’t important. The idea is that if everything is growing together (or shrinking together), the percentage allocation will stay closer to the original than if some things are growing and others are shrinking, or if some are growing (or shrinking) really slowly while others are growing (or shrinking) really quickly).
@s2000 magician
as per your example then shouldn’t it mean that higher correlations should have narrower corridors? If everything moves up or down together then it deviates less from its original allocations and so it doesn’t need as wide of a corridor?
The way to think of it is that it doesn’t need a narrow corridor. We prefer wide corridors: less rebalancing. If we can avoid narrow corridors, we’re happy.