@David_Snowball offered readers this month a peak inside his portfolio and an exercise in understanding portfolio risk using a MaxDD calculation. One thing that occurred to me was the timing or correlation of MaxDD for different assets held in a portfolio. Highly correlated assets would be additive as in David's example, but not all assets experience MaxDD at the same time. Cash has a MaxDD of inflation...always. Bonds and hard assets often expressed what I will call MaxFTS (Maximum Flight to Safety) at the very moment that equity assets are experiencing MaxDD. So holding a percentage of cash, Bonds or hard assets may very well serve at the best way to counter balance an equity asset's MaxDD.
I'll use David Snowball's table included here as a way to gauge a need for uncorrelated assets in a portfolio.
If these were my equity holdings I could approach the MaxDD risk I might hold an equivalent amount of cash equal to the impact MaxDD would have on these holdings. In David's example this would be
16.56% of what these holdings are worth at any given point in time. If this part of his portfolio (he states 55%) has a value of $
100K, then $
16,560 (plus inflation) might be held in cash. This would be where an investor could turn for distributions during MaxDD periods. This cash might also be used to buy discounted shares of these very same equity holdings that are experiencing MAXDD.
Bonds and hard assets in an portfolio could also serve both of these functions (distribution demand and reallocation). Bonds, especially those that experience a highly correlated MaxFTS, have proven themselves as a great counterbalance when equities falter. Here is a chart showing the benefit of holding uncorrelated assets (VFINX & EDV), the S&P 500 and Long Duration Treasuries.
I believe a well constructed portfolio needs to Ying while it Yangs. I'll assume that the rest of David's (the other 45%) portfolio includes some of these uncorrelated assets.
