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.
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