As we mentioned in a late-September edition of the AAII Investor Update e-mail newsletter, diversification benefits have become harder to achieve. Increased similarities in the performances of asset classes have raised risk levels and made it more difficult to achieve improved risk-adjusted returns by relying solely on asset class and sector selection skills. Even stocks within the S&P 500 are moving more closely together.
At issue is correlation, a term that describes how close the total return of one asset (e.g., large-cap stocks) is to that of another (e.g., commodities). A correlation of 1.00 means returns are identical, both in terms of the direction and the degree of the change. A correlation of –1.00 means returns are mirror opposites. The lower the correlation ratio, the higher diversification benefits. In a perfect world, you want investments that zig when your other holdings zag.
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Unfortunately, the world is far from perfect and correlations are moving closer to 1.00 instead of further away from it. Sam Stovall, Standard & Poor’s chief investment strategist, quantified this shift in a recent report. The table below shows his calculations.
The day after we discussed Stovall’s findings in our e-mail, the Wall Street Journal published an article discussing how large-cap stocks were increasingly being influenced by macro forces (e.g., economic news, daily market sentiment, etc.). Research from Barclays Capital was cited as showing stocks within the S&P 500 having a 74% correlation in mid-August and a 66% correlation in mid-to-late September. To put this number into perspective, between 2000 and 2006, Barclays estimates that the average correlation was just 27%.
This shift means asset classes and large-cap stocks within the S&P 500 are now more likely to move in the same direction than they have historically.
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