Yesterday I discussed the concept of diversification (what it is and what it isn’t) at a high level.

I wrote, “Diversification has very little to do with how many stocks, mutual funds and ETFs are in your portfolio. Rather, diversification is about the correlations between assets in your portfolio.”

“Correlation” may be a bit of a hazy, confusing concept for some so I’d like to provide a bit more color (literally and figuratively).

So, let’s start by taking a look at correlations between major asset classes in the matrix below.

A correlation of 1.00 means perfect correlation so that if Security A goes up 10% Security B also goes up exactly 10%. A value of 0.00 indicates no correlation (no relationship) between two securities, and -1.00 means perfectly inversely correlated so that if Security A goes up 10% Security B goes down 10% and vice versa.

Click image to enlarge. Data from YCharts, prepared by Melotte Financial Advisors.

The matrix shows the correlations of annual returns for major asset classes from 2000 through 2021. On the far right you’ll also see the annualized returns and volatility for each asset class as well.

We notice that the U.S. Dollar (bottom row) is a great diversifier for all the other major asset classes, although it’s long-term returns were very poor with a fair amount of volatility (returnless risk).

Therefore, the U.S. Dollar is something that I might use (and have been using) as a tactical (short-term) position. In other words, I wouldn’t hold the U.S. Dollar long-term in portfolios as I believe it will lose value over time but may find opportunities to use it in certain market environments or if I have a particular investment thesis I’d like to pursue (e.g. concerns about forthcoming stock market losses, deflation).

The same idea applies to Broad Commodities, which have poor long-term returns and A LOT of volatility. I would not include Broad Commodities as a long-term “core” position within portfolios. If I were to invest in Broad Commodities it would likely only be for a short time (< 3 years) and to pursue a specific investment thesis.

Generally, most investors’ largest allocations include U.S. Large Cap Stocks, Foreign Developed Market Stocks and Bonds.

Notice Treasury Bonds are the most inversely correlated asset with U.S. Large Cap Stocks (-0.45) and gold has no correlation with U.S. Large Cap Stocks (0.06).

Treasury Bonds have historically done a great job preserving wealth (or even appreciating significantly) when stocks were struggling. This year obviously being a very rare exception to that with both Treasury Bonds and stocks down fairly significantly on the year. Although Treasury Bonds appear to be resuming their safe haven role recently as Treasury Bonds (IEF) are up about 1.5% while U.S. stocks (SPY) are down about 7.5% over the last month for a 9% spread.

Meanwhile, the assets most correlated with U.S. Large Cap Stocks are U.S. Small Cap Stocks (0.92) and High Yield (Junk) Bonds (0.76).

I cannot tell you how many prospective client portfolios I’ve seen with a bunch of high yield bonds where the client thought they were diversified because they had “bonds” in the portfolio.

Two things are going on either: (1) they don’t realize they have a bunch of high yield (junk) bonds, and/or (2) they don’t realize high yield bonds don’t protect their portfolio when stocks are getting crushed. They might just see the word “Bonds” in the name of the mutual fund and assume, therefore, it’s a low-risk / safe asset.

There is very little diversification benefit offered by High Yield Bonds. If stocks are falling, chances are high yield bonds are falling as well. Hence, they’ve provided very little protection in recessions just when you needed protection the most! I’d be more keen on adding high yield bonds in the depths of recession in anticipation of a recovery on the horizon.

In any case, I hope this helps to provide a bit more clarity on what I mean by correlations in the context of diversification and provides a good foundation to build upon in future discussions.

Part 3 will be the final installment of this Diversification series and will compare an actual prospective client’s portfolio to a much simpler, more streamlined, better diversified and cheaper portfolio in light of what I wrote about yesterday. Stay tuned!

 

 

Disclosures:
Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.

Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.

This is not investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.

Views provided here are current only as of the moment of posting and are subject to change at any time without notification.

U.S. Large Caps Stocks = S&P 500 Total Return, U.S. Small Cap Stocks = Russell 2000 Total Return, Foreign Developed Market Stocks = MSCI EAFE Total Return, Foreign Emerging Market Stocks = MSCI Emerging Market Total Return, Global Bonds = Bloomberg Global Aggregate, U.S. Corporate Bonds = Bloomberg U.S. Corporate, U.S. Intermediate Treasury Bonds = Bloomberg US Treasury, High Yield Bonds = Bloomberg US Corp High Yield, Broad Commodities = Bloomberg Commodity Index, U.S. Dollar = ICE US Dollar Index.

 

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