“Correlated assets” is becoming the “fashion faux pas” of the investment world. Your portfolio might have looked good five years ago, but it’s just not working anymore.
The latest research shows that a diversified stock portfolio is now a somewhat contradictory concept. Whether it’s the proliferation of exchange traded funds , high frequency traders, or something else, the bottom line is that all types of stocks—large-capor small-cap—are showing a high degree of correlation.
The latest concern for investors, correlation, is best explained by the rap star Ludacris: “When I move you move.” Investors right now need to consider that all stock classes have a high probability of moving up, down, or sideways at the same time.
What's less easy to figure out is how to add diversity to your portfolio without adding more risk.
“Numbers don’t lie,” says David Stendahl of Signal Financial Group. Focusing on portfolio construction and risk management, Stendahl tracks short-term and longer-term correlation between asset classes. His data confirm that all equities have been highly correlated during the past 24 months.
By looking at percentage returns of a particular asset versus the S&P 500 Index, Stendahl can identify which assets will actually create diversification within an all-stock portfolio without adding excessive risk. His current recommendations to investment advisors include the euro, crude oil, and gold.
Other asset classes, including “lean hogs,” that have extremely low correlations with the S&P 500 do not offer the liquidity of the larger asset classes, and therefore are considered less desirable.
Investors need to remember that the goal of diversification is to smooth volatility and not necessarily to enhance returns.
In periods of high volatility, Stendhal says the best scenario is to have two assets in your portfolio with a near-zero correlation—and exactly what those non-correlated assets may be will likely change over time.
One more example of why investors need to reconsider "buy and hold" as their only investment strategy.
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Disclosure information was not available for David Stendahl or his company.