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TIGHTER CORRELATIONS REDUCING THE BENEFITS OF DIVERSIFICATION

By Charles Rotblut, CFA & Vice President with AAII

Diversification benefits have become harder to achieve. Increased similarities in the performances of asset classes have raised risk levels and made it more difficult to achieve improved risk-adjusted returns by relying solely on asset class and sector selection skills.

At issue is asset class correlation, a term that describes how close the total return of one asset class (e.g., large-cap stocks) is to that of another (e.g., commodities). A correlation of 1.0 means returns are identical, both in terms of the direction and the degree of the change. A correlation of -1.0 means returns are mirror opposites. The lower the correlation ratio is, the higher diversification benefits are. In a perfect world, you want investments that zig when your other holdings zag.

Unfortunately, the world is far from perfect and correlations are moving closer to 1.0 instead of further away from it. Sam Stovall, Standard & Poor’s chief investment strategist, quantified this shift in a report published earlier this week. The table below shows his calculations.

36-Month Total Return Correlations with the S&P 500
Index Average (1978-2010) Sep-10
Small-Cap Stocks 0.82 0.93
Int’l.—Developed 0.61 0.91
Int’l.—Emerging 0.50 0.85
REITs 0.51 0.85
Commodities 0.04 0.58
Bond Aggregate 0.25 0.46
Source: Sam Stovall, Standard & Poor’s

This shift means asset classes are now more likely to move in the same direction than they historically have.

If you are among those who feel like they’ve been doing everything right but aren’t making any headway, this merging of correlations may help to explain why. As asset class returns have more closely mimicked each other, it has become harder to reduce risk by combining a variety of investments within one’s portfolio. In more blunt terms, a downward move by domestic large-cap stocks now has an increased chance of dragging down emerging market stocks, REITs and commodities with it. Thus, it is harder to hide from the market’s dark side.

The performance bonus from minimizing risk for a given level of return (a key tenant of modern portfolio theory) has also been reduced. This, in no doubt, is driving portfolio managers nuts.

As gloomy as this all sounds, realize that diversification still a good thing. As the numbers published by Stovall show, returns are not completely correlated. In fact, bond performance continues to maintain a sizeable separation from stock performance. It’s just that the distance has become considerably shorter than it historically has been.

So, what do you do about this? First, accept the fact that we are in a difficult investing environment. I feel like Eeyore by saying this (and believe me, I’d much rather sound like Tigger), but reality is what it is. Though there is money to be made, there remain clouds over Wall Street.

A second strategy is to diversify even more, not less—the rationale being that not every asset class, sector or industry is going to move in exactly the same manner. On any given day, at least some investments are going to rise. By spreading your portfolio dollars around, you increase your odds of being in the right investment at the right time.

A third strategy is to look what you are holding in all of your accounts. Overlap between investments is not uncommon, especially for those who hold a taxable brokerage account, an IRA and a 401(k). Even though the accounts may be thought of as existing in different buckets, they all contribute to your overall wealth. Therefore, compare the holdings between all of your accounts and consider alternatives when similar funds or securities are held.

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