By Kevin Shuller
Diversify, diversify, diversify. If you've read any investing book written since 1952, it probably extols the virtues of diversification -- as well it should. But what you rarely hear discussed is what constitutes diversification, why it is important, and why avoiding misconceptions could save your retirement.
Investors usually understand the concept of diversification, but many have inaccurate perceptions about what provides actual diversification.
Many investors own an S&P 500 index fund and think, "I own 500 different stocks. I'm diversified."
But that's inaccurate. While owning 500 different stocks dilutes the risk that one of the stocks you own will dramatically underperform, it doesn't address the risk that the entire stock market might underperform. There is a big difference between having a diversified stock portfolio and a diversified investment portfolio. You want the latter.
Your goal as an investor should be to make sure that you own a collection of investments that will not move in tandem. For an asset allocation plan to work, you need to have asset classes that will rise when others are falling. You then have something to sell and can reallocate to a temporarily out-of-favor asset class. That's the true benefit of diversification.
Correlation: The Diversification Indicator
To understand diversification, we need to talk about correlation. Correlation is the extent to which two things move in the same direction and by similar amounts at the same time.
Sometimes high correlation exists for a reason. Sales of sunscreen and ice cream sandwiches are highly correlated, typically because consumption of both peak in the summer, and then ease back to their base levels in the winter.
Sometimes correlation is merely a fun statistical coincidence. From 1999-2009, there was a very high correlation between the number of people killed by venomous spiders and the number of letters in the winning word of the Scripps National Spelling Bee.
If you can think of a logical connection between the two, you are more creative than I am.
Correlation is expressed by numbers between +1 and -1. Positive correlation means the two things in question move in the same direction. In the world of investments, think of two stocks in the same industry. When the auto industry sees good news, it is likely that both Ford and GM will be positively affected. You would expect both stocks to rise and fall together. Negative correlation means the two things move in opposite directions. One of airline companies' biggest expenses is jet fuel, the price of which is tied to crude oil prices. When crude prices spike, airline profits may stumble, and take their stocks with them. Crude up, airline stocks down. They are negatively correlated.
Portfolios with high positive correlations don't give you many opportunities to benefit from rebalancing. If you hit a rough patch in the markets, there will be nowhere to hide.
If you are already in retirement and making withdrawals, you may be forced to sell stocks in a down market. Capital losses in retirement are tough to recover from if you don't have employment income to reinvest or a cash cushion to wait for a stock market recovery.
The goal of portfolio construction is having non-correlated assets that provide positive returns. Many people, investors or not, confuse non-correlated and negatively correlated. Negatively correlated means that when one goes up, the other goes down.
With non-correlation, the price action is completely unrelated. One price goes up, the other price does whatever it wants. Let's say I make you an offer: You put up as much money as you want. Once a month, we will flip a coin. If it's heads, you win +3.4% of your investment. If it's tails, you lose -1.7%.
Over the course of the year, you would expect to gain +10.4% on this investment, which is the average annual return of the S&P 500 over the past 100 years. Let's say you are also invested in the stock market, the market and this coin toss are two totally unrelated investments. The performance of the stock market will have zero impact on the outcome of our coin toss and vice-versa. However, a 50/50 split between the S&P 500 and our coin toss investment rebalanced monthly would return +10.8% annually and would be less volatile than either investment on its own.
It's important that the average level of correlation among your assets be low. Correlations aren't static. They can and will change over time, which is why you should focus on the average.
Take, for example, the rolling 20-week correlation between the S&P 500 and long-dated U.S. Treasury bonds. It can swing wildly. It rises as much .75 and falls as much as -.75. There are some periods where the correlation is high enough that you don't get a great diversification benefit, but over time there is a very low correlation between long-dated Treasuries and the S&P 500.
That's why bonds make an effective diversification partner for your stock portfolio. In fact, the first three months of this year was the first quarter since the third quarter of 2008 in which both the S&P 500 and the Barclays Aggregate Bond Index were down in the same quarter. It's only happened eight times in the past 30 years, or less than 7% of the time.
Let's compare that to the correlation between U.S. small-cap stocks (the Russell 2000), and U.S. large-cap stocks, via the S&P 500. While there are moments of low correlation, the average correlation is around 0.9. This means you don't get as much of a diversification benefit by adding small-cap stocks as you do adding bonds to your U.S. large-cap portfolio.
Positive correlations are great when everything is going up, but are a disaster when things are going down. There is a saying: In a crisis, all correlations go to 1.
We saw this happen during the 2008-09 credit crisis. As stocks collapsed, investors tried to sell everything that wasn't tied down -- stocks, bonds, collectibles, etc. As a result, asset prices all moved in the same direction -- down. That's what made the crisis so difficult to weather. There was nowhere to hide. Investors who would normally rebalance their portfolio by selling high and buying low, found they had nothing to sell.
How to Add Real Diversification
All investors should be more conscious about how their retirement assets interact with each other. Remember, you want total independence in terms of performance and price movement. If your portfolio is primarily U.S. large-cap stocks, adding U.S. small-cap stocks won't give you nearly the diversification benefit that adding bonds or international stocks will.
You can apply your knowledge of correlation to the stocks and bonds you own. Try to look at the correlations of the types of stocks/bonds you own. Need more diversification in your stocks? Compare the correlations of small caps and of international stocks to large-cap U.S. stocks before deciding which will help bring you real diversification benefits.
If you want to know how asset classes interact, check their correlations. It's easiest to compare either two indices or long-lived ETFs for the asset classes you are considering. You can use Excel, a piece of charting software, or one of many free correlation tools and charts online. If the correlation is usually above 0.9, it won't provide you as much diversification as you need.
Stocks and bonds make up the foundation of a diversification plan. The performance and volatility benefits of maintaining a relatively consistent 60/40 split are well-documented, so I'm not going to rehash them here.
This is also where alternative investments come in. Historically, this has meant hedge funds. In the past 10 years, there has been an explosion in liquid alternatives. These products offer strategies that originated in hedge fund structures, but don't have the roadblocks that kept people out of hedge funds. These alternatives are widely available and provide more liquidity than private investments. While they usually come with hefty management fees, many of them produce returns with low correlation to the market.
When you are planning your own retirement, it is important to be mindful of what constitutes diversification and what doesn't. Owning a lot of securities might make you think you are diversified, but if they all act the same way, you aren't diversified. Don't be afraid of the esoteric sounding concept of correlation. Knowing it and examining its levels inside your portfolio could be the key to surviving the next downturn.
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About the author: Kevin Shuller, CFA, is the director of Investment Research at Shine Investment Advisory Services, a wealth management firm in Lone Tree, Colo. Shuller is also a member of the FPA of Colorado. The opinions expressed in this article are those of the writer and not necessarily those of the Shine Investment Advisory Services.