Diversification is Difficult When Correlations are Rising
June 30, 2013 | Topics: Alternatives
- A goal of diversification is to build a portfolio of investments that have low correlation to each other
- Over the past 15 years, a portfolio invested 60% in stocks and 40% in bonds has had a near-perfect correlation to the stock market
- Alternatives can help lessen the correlation of a traditional portfolio to the stock market, potentially dampening the effects of market volatility
What is Correlation?
Correlation measures the strength of the relationship between two investments' returns and can range anywhere from +1 (perfect correlation) to -1 (perfect negative correlation). If two investments are perfectly correlated, they will always increase or decrease in value at the same time. Conversely, if two investments have a perfect negative correlation, they will always move in opposite directions.
A goal of diversification is to build a portfolio of investments that have low correlation to each other so that not all of the portfolio's investments are moving in the same direction at the same time, particularly on the downside. This results in the portfolio as a whole having a low correlation to the broader markets and the investor less at the mercy of extreme volatility.
Traditional Diversification Strategies Don't Work Anymore
It used to be that a mix of small-, mid- and large-cap stocks could help minimize a portfolio's correlation to any one individual stock benchmark, for instance, the S&P 500 Index. To further diversify and take down this risk even more, an investor could include international stocks to broaden global exposure as well. However, over the past few decades, this option has become less and less attractive for investors as the correlation between U.S. and international stocks has steadily risen.1
Bonds Are an Incomplete Answer for Lowering Correlation to the Stock Market
Investors have long used bonds as a way to diversify a stock portfolio, for instance, think of a typical portfolio consisting of 60% stocks and 40% bonds. In the past, this strategy was generally successful, achieving investors a sizable return with moderate risk. During the 1990s, a 60/40 portfolio returned nearly 13% a year with volatility just over 8%. However, more recently this strategy has lost much of its prior effectiveness, with returns of about 4% and volatility increasing above 10%. During the same time, this 60/40 portfolio had a correlation of 0.99 to a portfolio that was invested entirely in stocks.1
Alternatives Can Offer Lower Correlation and Help Protect From Volatility
The purpose of combining investments with low correlation is to provide greater diversification so that not everything in the portfolio moves in tandem. Because they tend to have lower correlation to stocks and negative correlation to bonds, alternatives can be an attractive diversifier. This can lead to additional insulation against market volatility, preserving the value of an investor's portfolio.
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1 Source: Bloomberg, Barclays Live. Investing involves risk. Past performance does not guarantee or indicate future results. 60/40 portfolio is represented by 60% S&P 500 Index and 40% Barclays U.S. Aggregate Bond Index rebalanced quarterly. Annualized returns based on quarterly data for each index from 1990 to 2000 and 2001 to 2011, respectively. Risk is based on the standard deviation of the quarterly return series from 1990 to 2000 and 2001 to 2011. Indices are unmanaged and it is not possible to invest directly in an index. The returns of these indices do not reflect the deduction of any sales charges or fees. The performance and risk information above reflects relative returns and risk information only for the periods indicated. Use of other beginning or ending points, or of a longer or shorter period, would result in different relative performance and risk information.
The information on this Web site is intended for U.S. residents only. The information provided does not constitute a solicitation of an offer to buy, or an offer to sell securities in any jurisdiction to any person to whom it is not lawful to make such an offer.
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Hedge funds may not be suitable for all investors and often engage in speculative investment practices which increase investment risk; are highly illiquid; are not required to provide periodic prices or valuation; may not be subject to the same regulatory requirements as mutual funds; and often employ complex tax structures.
Utilizing private equity involves significant risks along with the opportunity for substantial losses.
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