Correlation is a measure of how much or little investments move in sync with each other. Complete correlation is 1.0. Opposite correlation is -1.0.
To construct a truly diversified portfolio, it is preferred that holdings respond differently to various market conditions and economic cycles. If investments move together with high correlation, they offer less risk management.
Historically, non-U.S. stocks have added diversifying qualities to an overall investment portfolio because their correlation to U.S. stocks was not high. But that has changed significantly. While international stocks do provide access to different economies, currencies and sources of earnings, their performance pattern has become less distinguishable from U.S. stocks.
Consider this information from J.P. Morgan.
During the 2008 financial crisis, many investors realized that although a concentrated portfolio may build wealth, a diversified portfolio protects it. High correlations among volatile asset classes can rapidly reduce a portfolio’s value, and although equity correlations have remained elevated since the crisis ended, this is not a post-crisis phenomenon. As shown in this week’s chart, the correlation among international equity markets has been on an upward trend over the past 20 years, likely due to these markets becoming increasingly interlinked through technological advancement and easier investor access. Thus, given that markets remain macro-driven and average correlations are 5x higher today than in the mid 1990s, under-diversified investors could be at serious risk, once again making a strong case for taking a balanced and diversified approach to investing.
Source: MSCI, Standard & Poor’s, FactSet, J.P. Morgan Asset Management.
While we believe it is important to be a global investor, it is also important to include investments in your portfolio that are not highly correlated with global stocks. Using low correlation assets can be very important, particularly in times when global stocks are declining. Notice in the graphic that the peak of correlation among global stocks came at the height of the 2008-09 crisis, exactly when less correlation would have been most valuable.
Do you know what level of correlation your investments have to each other?
Is your portfolio built to buffer down-market risk more than chase all the return of bull markets?
What is your definition of diversification?
Past performance does not guarantee future results.
Diversification does not guarantee investment returns and does not eliminate the risk of loss.
By Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management — Tacoma, WA