Correlation of Returns: The Reason Why Diversification Didn’t Work

None of the alternative investments provided sufficient risk reduction to soften the impact of the Bear Market. Alternatives such as Commodities, Equity REITS, International Equities doesn’t seem to be working. The U.S. Treasuries were one of the few asset classes that really provided sufficient diversification. What went wrong?

First let’s address the question of “Diversification doesn’t seem to be working. What went wrong?” A common refrain during this financial crisis has been:

I am as diversified as it gets. My portfolio has every asset class imaginable. I own lots of and have substantial exposure to small-cap value and international stocks. Yet every single asset class dropped pretty much the same during this downturn. As far as I can tell there was no protection at all from owning all these asset classes. I would say that during a steep downturn diversification does not protect.

What went wrong? Absolutely nothing. The problem was that the investor did not fully understand the concept of correlation of returns­ — a common error.

Correlation of Returns

Prudent investors building portfolios that include asset classes that have low correlation ­the measure of the strength of the linear relationship between two variables. Values can range from +1.00 (perfect correlation) to -1.00 (perfect negative correlation). Two assets are positively correlated means that when one asset produces above average returns, the other tends to also produce above average returns. Conversely, negative correlation means that when one produces above average returns, the other tends to produce below average returns. Thus, the lower the correlation of returns, the more effective the asset class is as a diversifier of portfolio risk.

Note the relatively low annual correlations of the various asset classes to the S&P 500 Index for the period 1988-–2007.

Based on these historical relationships, investors expect that while all asset classes will do poorly from time to time, the low correlations of the various asset classes will prevent them from all doing poorly at the same time. Unfortunately, investors make the mistake of not putting enough emphasis on the key words, tends to.

The problem for investors is that they fail to understand that correlations are not stable­ — they drift. And while international stocks and emerging market stocks are exposed to some different economic and political risks than are U.S. stocks, they are also exposed to some of the same risks that can impact the global economy. And when those risks show up (­typically during times of financial and/or political crises),­ correlations among all asset classes tend to turn high. Just when the benefits of diversification are needed most, they go AWOL.

One of my favorite expressions is that “the only thing you don’t know about investing is the investment history you don’t know.” Knowing the history of returns would have prevented investors from misunderstanding the benefits of equity diversification. The latest financial crisis revealed nothing new about correlations. For example, all major equity asset classes produced negative returns during the global recession of 1973-1974 as the S&P 500 Index, large value stocks, small stocks, small value stocks, and international large stocks fell 37, 20, 53, 46 and 34 percent, respectively. There was no place to hide.

The same thing happened both during the Asian contagion during the summer of 1998, when the world equity markets were hit by the “Asian Contagion” and in the aftermath of the events of September 11, 2001. And the systemic risk of equities showed up again when the financial crisis that began with U.S. housing prices falling sharply spread around the world in the summer of 2008. Every major equity class experienced a dramatic bear market. In some cases, it was the worst since the Great Depression.

The Lesson

Most of the time, risky asset classes do not exhibit very high correlation. And many even have very low correlations. Among the asset classes that on average have low correlation with U.S. equities are real estate, international small-cap stocks and emerging market stocks.

The reason for the low correlations is that most of the time economic and political conditions impact the various asset classes in different ways. That explains the low long-term correlations. However, in times of global crisis, all risky assets tend to correlate highly. And that leads us to the important lesson the markets teach us. In times of crisis the only effective diversifier of equity risk is very high quality fixed income investments­ the safest of which are obligations that carry the full faith and credit of the U.S. government. During this crisis, while all equity asset classes were experiencing severe bear markets, U.S. Treasury instruments were providing positive returns.

Before concluding there is one more important point we need to address.

Is the Investment World Flat?

The financial media has been filled with stories about the rise in correlations. The story goes something like “we are becoming one global integrated economy…….” Thus, the benefits of diversification are greatly reduced. It seems that this has even become the new conventional wisdom­ — an idea that is so accepted that it goes unchallenged.

However, before one accepts such “wisdom” we can look at the evidence. Consider the correlations between the S&P 500 Index and the EAFE Index. From 1970-2007 the annual correlation was 0.586. By dividing the full period in half we can see if there has been any trend toward rising correlations as the “world has become flat.”

During the first half, from 1970 through 1988, the annual correlation was 0.623. During the second half, from 1989 through 2007 the annual correlation was 0.614. Obviously, there has not been a general rise in correlations. The recent rise in correlations is a result of the financial crisis, nothing more.

We have had crisis in the past, and we will have them in the future. And each time the correlation of risky assets will rise, as they always have done.

Conclusion

It is important that investors understand that correlations are not static­ — they do drift. And correlations are likely to rise to very high levels during times of crisis. Thus, the winning strategy is to make sure that your portfolio has a sufficient allocation to high quality fixed income assets­ — an amount sufficient to dampen overall portfolio risk to the level that does not exceed your ability, willingness and need to take risk.

Spanish philosopher George Santayana said: “Those that do not remember the past are condemned to repeat it.” The financial markets have provided investors with enough lessons that there was no reason to make an error such as believing that broad global diversification across equity allocations would protect one from bear markets.

Investors who do not have sufficient amounts of high quality fixed income assets to reduce overall portfolio risk to an acceptable level are likely to fail the tests that the markets provide from time to time. And given the depth of this bear market, this test might have been the final exam for many.

Finally, it is important to understand that even smart people make mistakes. But, only fools repeat or perpetuate them. Therefore, if your portfolio does not have a sufficient allocation to high quality fixed income assets, you should immediately rewrite your asset allocation plan to correct that error — ­an error that proved damaging to many investors portfolios.

A Few Words About Managed Futures

Now turning to the issue of managed futures. This is somewhat addressed in the book, The Only Guide to Alternative Investments You’ll Ever Need, in the commodities chapter. See page 55 and the discussion of CTAs, Commodity Trading Advisors.

The bottom line is that I cannot recommend them. Keep this in mind, futures trading of any kind has no expected return, unlike investing in stocks and bonds — you get an expected return for taking risks. With futures you always have a zero sum game even before expenses — the net expected return must be zero because for every winner on a trade there is an offsetting loser. And then you have the expenses of these “investments.” I put the quotation marks around them because I view them as speculations not investments.

Disclaimer: Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.

Larry Swedroe

Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You’ll Ever Need (2008).

Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!