Nobel winner, Harry Markowitz explicitly said in his paper, Portfolio Selection (attached), “It is necessary to avoid investing in securities with high covariances among themselves.” He also said to invest in an asset class one has to have “beliefs about the future performances of available securities.” Therefore the question becomes, how many asset classes are truly required to develop a fully diversified strategy. In their 2018 paper, When Diversification Fails, authors and T. Rowe Price portfolio managers, Sébastien Page, CFA, and Robert A. Panariello, CFA conclude: “diversification seems to disappear when investors need it the most. We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss.” They recommend during downturns: “government bonds almost always rally because of the flight-to-safety effect (Gulko 2002). In a sense, duration risk may be the only true source of diversification in multi-asset portfolios. Therefore, the expected stock-bond correlation is one of the most important inputs to the asset allocation decision.” So the answer is stocks and bonds are the 2 asset classes required to create a diversified portfolio precisely because of their correlation coefficients.
Abstract: In this paper, we build on the 2016 paper. In addition to the use of fundamental asset class inputs, we added technical inputs to make the asset allocation changes more robust. For a short-term trend indicator, we used the Elliott Wave Oscillator. For an intermediate-term indicator, we used the golden cross. We find a cumulative asset growth advantage of 58% vs. a 100% stocks allocation and 70% vs. a strategic asset allocation approach (60% stocks, 40% bonds) from October 1992 through September 2020.
Here’s the xlxs-