NEW YORK (MainStreet) – When financial markets are jittery, many investors boost their cash holdings, a surefire way to insure against loss. But now there’s another, more subtle reason to boost cash: the high correlation between asset classes such as stocks, bonds and commodities.
Correlation is the tendency of two or more assets to move up or down in tandem. In dividing an investment portfolio between various assets, most investors seek a low correlation. That way, when your stocks dip, your bonds may rise, for example. Low correlation is the reason to diversify, or divide your eggs among various baskets to reduce the volatility of the overall portfolio.
But there’s a glitch in the system. A study by market-data firm Morningstar Inc. finds that the correlation between nine of 11 key asset classes has increased during the past 10 years, undermining the benefits of diversification.
Correlation is measured on a scale from negative 1 to positive 1. Positive 1 means the two assets are in perfect lockstep, with asset B moving up or down exactly as asset A. Negative 1 means the assets move opposite one another, so that when A rises 10%, B falls 10%.
Investors seeking low correlation want a smaller number – the closer to negative 1 the better. Unfortunately, that’s become harder to find.
Morningstar uses the Standard & Poor’s 500 stock index as the base for comparison. Druing the past 10 years, the correlation between this index and the MSCI EAFE index, which includes stocks from developed countries outside of the U.S. and Canada, has climbed from 0.47 to 0.68, increasing the correlation.
Similarly, the correlation of the Dow Jones Real Estate Trust, a gauge of real estate investments, with the S&P 500 has gone from 0.59 to 0.91. The figure for the Dow Jones UBS Commodities Trust, measuring a basket of commodities, has gone from 0 to 0.46.
Of the 11 indexes, the only two showing reduced correlation are the BarCap. U.S. 7-10 Year Treasury Index, going from -0.21 to -0.60, and the BarCap U.S. Aggregate Bond Index, falling from -0.18 to -0.52. Both are bond indexes heavy in investment-grade U.S. bonds, such as Treasuries and corporates.
This negative correlation would, in theory, make investments in those types of bonds a good way to diversify a portfolio that also contains stocks, real estate and commodities. Unfortunately, beefing up on bonds might not be a good way to make money right now, as bond prices could plummet if interest rates were to rise from today’s unusually low levels.
Morningstar says it is unclear exactly why these correlations have increased, but suggests that a key factor may be the fallout from the market crash of 2008. Nervous investors may have developed a “risk-on/risk-off sentiment” that causes them to flood in and out of all types of investments at once, based on whether they see the markets overall as risky or safe.
The rise of new investment products may be another factor. Today it is easy to move money in and out of real estate and commodities with real estate investment trusts and exchange-traded funds. By making these assets more liquid, these vehicles make them more susceptible to investors’ risk-on/risk-off behavior.
As a result of rising correlation, a portfolio that looks widely diversified may not be. Until the trend reverses, there also may not be much to do about it other than keep a large cash reserve as a stabilizing force.
A simple savings or money-market account would do the trick. Yields will be pathetic, but your cash will be federally insured against loss, which could be a life saver if all the other assets in your portfolio head south at the same time.
While a diversified portfolio is always important, there are different investing rules for different times of your life. Check out MainStreet’s Guide to Investing in Your 30s to set up your portfolio the right way!