by ETFguide | December 5, 2012 8:59 pm
Think you are protected from another 2008? Think again.
Your portfolio is not nearly as diversified as you think, especially if you hold the usual suspects of domestic small, mid, large, and foreign stocks.
In 2008, investors that thought they were protected through diversification were subject to larger losses than expected as correlations soared. Nothing was safe as most assets fell in value. Most advisors and strategists of course wrote it off as a one-time anomaly. Domestic stocks (NYSE:IVV), foreign stocks (NYSE:EEM), housing (NYSE:XHB), even many bonds (NYSE:LQD) all lost significant value and fell together. This alone was somewhat unprecedented.
The troubling thing is this extreme correlation amongst assets still exists today. Even though markets have recovered on the upside and things are “back to normal” on Wall Street, the correlations have not reverted back to their historical (and arguably more logical) levels. As a result, risk in your portfolio is likely a lot higher than you (or your advisor) realize.
Correlation involves some complex math but is important because it is the primary measuring factor of your portfolio’s diversification (or lack thereof).
A correlation of -1 means the two assets move opposite each other at all times and the greatest diversification benefit exists. A correlation of -0- means there is no apparent dependence between two assets, and diversification benefits likely exists. The closer to +1 the correlation is, the higher the dependence between the 2 variables, the closer the 2 assets move in unison to each other, and the diversification benefit disappears.
A correlation closer to zero is where most asset classes were before the 2008 crisis. Many even had negative correlations. Now most sector, index, and country equity correlations remain at the upper end of the spectrum approaching +1, and that is worrisome.
Have you noticed that when European (NYSE:VGK) stock markets fall, so do American (NYSE:VTI) stock markets? When Silver (NYSE:SLV) goes up in price so does the Euro (NYSE:EUO)? These are all symptoms of increased correlation and are dangerous to your portfolio’s diversification.
The chart below shows the Energy Select Sector SPDR (NYSE:XLE) and the Financial Select Sector SPDR (NYSE:XLF) ETFs from 2001-2007. The top of the chart shows the stock prices of the two with the bottom line highlighting the correlation between them through time.
The key takeaway is the correlation chart at the bottom and its fluctuations. Notice correlation ended 2007 at -.18 (highlighted in red) and fluctuated in and out of positive and negative territory a number of times in that seven year period. A correlation in the negatives means an investor is getting some diversification benefit from holding both of the assets as their prices move somewhat opposite of each other. A person holding XLE and XLF during this time period received some diversification benefit and was somewhat protected when the 2008 financial crisis started as energy stocks remained elevated while financial stocks fell.
Once the financial crisis started, energy and financial stocks vaulted upward in their correlation…and they never came back down, and that is the scary part. Notice today the comparable correlation over the last 100 days is now .78.
Not only did the correlation go from negative to positive since before the crisis it has skyrocketed up to .78. Notice too that the correlation has not once dipped into the negative territory since 2008 and has remained extremely elevated since 2008 drifting at or near 1.0 for months at a time. This means there is now very little diversification protection by holding both of these indices in your portfolio.
Since the financial crisis, virtually all historically uncorrelated assets remain extremely correlated. Think you are diversified because you own bank stocks and energy stocks? Think again. Foreign (NYSE:FGK) versus domestic markets? Also now extremely correlated. Currencies (NYSE:FXE), precious metals (NYSE:GLD), even some bonds (NYSE:JNK) are significantly more correlated today than they were before 2008 and likely will provide little protection in the event of another high risk event.
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