A key investment principle is the need to diversify one’s investments. This principle harkens back to the proverbial “don’t put all your eggs in one basket.”
As an example, consider an individual employed by Microsoft who holds an investment portfolio consisting solely of Microsoft stocks and Microsoft bonds. This would not be prudent since any future event pushing the company towards insolvency could have devastating effects on both the individual’s employment and life savings.
So, rather than trying to pick specific securities, investors buy funds that are widely diversified, or even approximate the whole market.
One of the reasons that diversifying an investment portfolio over many securities helps reduce risk is that individual stock and bond returns do not necessarily move up and down in tandem. Some securities will zig while other securities zag. The statistical concept that measures these co-movements is called correlation.
If we have two investments providing the same returns, but move in exact opposition– that is, are perfectly negatively correlated– we see that combining the two investments provides for a smooth non-varying return.
In the real world of investments, asset returns are rarely negatively correlated. In most cases the correlations are positively correlated or uncorrelated. Combining investments with low correlations can still provide reductions in portfolio return variance.
In the table below each asset pair returns a simple arithmetic return of 5% a year, but with differing correlations: negative correlation (-1.0); no correlation (0.0), and positive correlation (+1.0) (see note).
|Portfolio||Correlation of assets||Simple average return||Compound return||Standard deviation|
|50% C+ 50% D||-1.0||5.00%||5.00%||0.00%|
|50% A+ 50% B||0.0||5.00%||4.60%||10.00%|
|50% E+ 50% F||1.0||5.00%||4.20%||14.00%|
Asset class diversification
U.S. stocks and international stocks do not have perfect positive correlation due to having differing business cycles, and to the cycles of currency valuation.
Likewise, U.S. stocks and treasury bonds usually have low positive correlation.
However one must keep in mind a few caveats when considering the correlation of asset class returns.
- Correlation is varying over time, so asset classes will have higher and lower correlation over different periods.
- When equity asset classes experience large drops in value, many asset classes tend to grow more positively correlated.
Time varying correlation
We can see the time varying quality of asset correlation by examining the chart of CRSP US total equity and 5-Year Treasury notes.
As illustrated in the table above, the risk reduction and potential return enhancement of combining treasury bonds to US equity will be more pronounced during periods when the correlation of returns is low or negative, and less pronounced when the correlation is more highly positive.
Increased asset correlations
Fidelity notes that “During the 2008–09 bear market, the correlations of U.S. stocks to virtually every type of asset except Treasury bonds increased sharply. As the chart below shows, the correlations of U.S. stocks to international stocks and high-yield bonds jumped to nearly 90%. Investment-grade bonds and cash went from being negatively correlated to U.S. stocks to being positively correlated. All this reduced the effectiveness of diversification during this period.”
- 5 yr treasury correlation chart : CRSP US total equity and 5-Year Treasury notes from the DFA Returns program. Correlation calculations by Rick Ferri.
- Table derived from Ferri, Richard A., All About Asset Allocation, p.41.