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A Market Lacking Diversification

Correlations have increased across the market, but a few bastions of diversification remain.

Abraham Bailin, 01/25/2012

We've all heard the saying, "Don't put all of your eggs in one basket." The idiom doesn’t raise any eyebrows; it's intuitive. If you drop the basket, you break all of your eggs. If, on the other hand, you place half of your eggs in a second basket, dropping one basket renders only half as much culinary carnage. If only in a very simple and cutesy manner, the phrase speaks to a profound investment doctrine: diversification.

With regard to the egg idiom, the driving intuition is downside protection. Diversification allows one to significantly limit the potential for catastrophic loss. With regard to financial assets, however, short-term losses are generally not catastrophic. The interesting point is that there are benefits to diversification, even in the case that assets increase in value over time.

To Add Diversification, Find Low Correlation!
When selecting investments that provide the benefits of diversification, identifying products that do not move in unison is crucial. After all, we want to select investments whose price movements (that is, volatility) will negate one another. We measure this via a metric called correlation. We'll save the math, but investors looking to introduce diversification to their portfolios should understand the intuition behind the metric.

Effectively, correlation tells you how likely investment A is to move up, given that investment B has moved up, and vice versa. The metric runs from negative 1 to 1. A value of 1 indicates perfect correlation, whereby both asset prices fluctuate in unison. A value of negative 1 indicates perfect inverse correlation, whereby the assets move in opposite directions to the same degree.

Note that any correlation less than 1, even .999, allows you to add diversification. This is because anytime that the two assets do not have identical price performance, splitting your assets between the two will smooth your volatility profile. That said, you are likely to see a much higher degree of diversification when selecting an investment with very low correlation.

Like Searching for Water in a Desert!
When people talk about the correlation of a particular asset, they often do so with regard to the broad U.S. equity space. More specifically, they do so with regard to the S&P 500. Recently, correlations across virtually all assets have increased. This means that diversification benefits are far sparser than they were in previous years.

Note the change in the correlations of the various asset classes to the S&P 500 below. The correlation figures measure average trailing 12-month, or TTM, correlations using daily returns.

Abraham Bailin is an ETF Analyst with Morningstar.

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