People routinely complain that asset class correlations can increase dramatically in market downturns – meaning basically everything goes down at the same time defeating the purpose of spreading your eggs around different baskets. This leads to questions about the value of diversification. Is it failing? Is it different this time? Is there a new normal?
No, no and no.
Pretty much every stock index is down on a year-to-date basis, but additionally the correlations of stocks within indices are also on the rise. The correlation of the top 250 stocks in the S&P 500 is 81 per cent. It was 88 per cent on Black Monday, Oct. 19, 1987. And the long-term average is about 30 per cent.
But how many people have a 100-per-cent equity portfolio? Have we forgotten about bonds? The DEX Long Term Bond Index is up almost 12 per cent on a year-to-date basis and the DEX Universe Bond Index is up about 7 per cent (as of close on Sept.14). Diversification between asset classes is going to include allocations to fixed income for all but the most aggressive investors. A simple 50/50 mix of exchange-traded funds tracking the TSX Capped Composite Index and the DEX Universe Bond Index would still be in positive territory from the beginning of the year until the end of August.
So, the first counter argument is that not all asset classes are in fact going down.
But beyond this simple fact, asset class correlations are not static over time. More often than not, they are low enough to provide benefit (low correlation is good). We just talk about the few periods of high correlations out of fear and uncertainty. Just like how buy-and-hold is dead in every bear market too.
Eventually, we will see that simply sticking to your plan was the most prudent course of action so long as it was set up properly in the first place. We will hear confessions from investors who couldn’t stand the declines and sold out only to miss the market recovery. This is telling of too aggressive a mix between stocks and bonds.
We will see a similar pattern when asset class correlations come down. Domestic markets might stagnate while a few emerging markets shoot the lights out, or vice versa, and the data will reflect that diversification still works overall.
Just as stocks will not always beat bonds, correlations will not always be low. That’s been the normal for a long time.
Preet Banerjee, B.Sc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com. You can also follow him on twitter at @PreetBanerjee