So what happens if I just select the 10 cities with the lowest volatilities and allocate 10% to each one without any regard to the correlations amongst the cities?
Answer: since the volatilities are less ephemeral than the correlations, this is a good solution. Maybe not perfect and I know there are more sophisticated methods available, but for someone like me with limited mathematical abilities this is a good practical alternative. As shown in the chart above, the cities with the lowest volatilities in the first 10 years tend to maintain these characteristics during the subsequent out-of-sample test.
For the sake of comparison, the average volatility of the 10 selected cities during the first 10 years was 2.8%, which is lower than the average volatility of the 25 cities of 4.2% during that period. During the subsequent out-of-sample test, the realized volatility of the 10 selected cities remained only 2.8% while the volatility of the 25-city portfolio actually increased to 4.6%.
Take-away: to minimize volatility, just allocate amongst the least volatile constituents.
Big Take-away: Be sure to conduct an out-of-sample test, so you don't get fooled by randomness when trying to answer a question based on historical data.
Quote for the Week: "The return of your investment is never the direct payoff of any one thing, but from the self-knowledge and connections gained by getting one's hands dirty. Much of success is dreaming about finding gold, and then discovering you can get rich selling shovels to gold miners. There are many examples of businesses founded on unique business selling points that, with hindsight, were wrong. This is the one thing ignorant but ambitious young people have that their more knowledgeable and older colleagues are envious of. Young people have the time an energy to discover [what] older people do not, but this assumes one actually invests this time and energy doing things, and does not just talk about them. In searching for alpha, you often have dreams that are often ill-founded, but they can actually be beneficial, because they offset the general under-appreciation of the option value of trying things and then learning an incidental skill that introduces you to new opportunities." -Eric Falkenstein, author of Finding Alpha
