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    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.

    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.

    If you are among those who feel like they’ve been doing everything right but aren’t making any headway, this merging of correlations may help to explain why. As asset class returns have more closely mimicked each other, it has become harder to reduce risk by combining a variety of investments within one’s portfolio. In more blunt terms, a downward move by domestic large-cap stocks now has an increased chance of dragging down emerging market stocks, real estate investment trusts (REITs) and commodities with it. Thus, it is harder to hide from the market’s dark side.

    Small-Cap Stocks 0.82 0.93
    International—Developed 0.61 0.91
    International—Emerging 0.50 0.85
    REITs 0.51 0.85
    Commodities 0.04 0.58
    Bond Aggregate 0.25 0.46

    As gloomy as this all sounds, realize that diversification is still a good thing. As the numbers show, returns are not completely correlated. In fact, bond performance continues to maintain a sizeable separation from stock performance. It’s just that the distance has become considerably shorter than it has been historically.

    So, what do you do about this? First, accept the fact that we are in a difficult investing environment. Though there is money to be made, there remain clouds over Wall Street.

    A second strategy is to diversify even more, not less—the rationale being that not every asset class, sector or industry is going to move in exactly the same manner. On any given day, at least some investments are going to rise. By spreading your portfolio dollars around, you increase your odds of being in the right investment at the right time.

    A third strategy is to look what you are holding in all of your accounts. Overlap between investments is not uncommon, especially for those who hold a taxable brokerage account, an IRA and a 401(k). Therefore, compare the holdings between all of your accounts and consider alternatives when similar funds or securities are held.

    Finally, realize that correlations tend to rise in reaction to volatile market conditions and increased uncertainty. Over the long term, diversification and smart asset selection (be it individual securities or specific funds) does work.

    Sources: AAII Investor Update e-mail (September 23, 2010); Standard & Poor’s Global Equity Strategy (September 20, 2010); Wall Street Journal, “‘Macro’ Forces in Market Confound Stock Pickers,” September 24, 2010.


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