Finding Real Diversification

The fact that diversification is crucial to reaching your financial goals isn't exactly an earth-shattering concept. For years, experts of all stripes have been urging investors to not put all of their eggs in one basket.

It's not bad advice. Having a group of assets that perform well while other parts of your portfolio are doing poorly can help smooth returns and reduce risk over time. It also diminishes the risk that one of your holdings will have an enormously destructive impact on your portfolio.

But gaining diversification can be much easier said than done. Simply buying more and more securities doesn't necessarily give you any diversification benefit. If you own 100 regional banks, you've likely protected yourself against the idiosyncratic risk that one bank will fail, but you've done nothing to protect yourself against systemic risk or a banking crisis. To get real diversification, you need to find assets that truly behave differently from one another over time.

We examined the correlations between several major stock, bond, and alternative indexes to see where investors could find this real diversification. Correlation is a statistical measure that shows how two securities move in relation to each other. A correlation coefficient of 1 implies that the two would move in lock step in the same direction. A coefficient of negative 1 means they move in lock step but in opposite directions, and a coefficient of 0 means there is no relationship between the two securities.

Although this is obviously not an exhaustive study, we discovered that during the last three years, correlations between stocks and bonds remained low while correlations within asset classes were fairly high. Further, the diversification record for "alternatives" such as commodities and real estate has generally been mixed.

The indexes and funds we tested were:

• Morningstar U.S. Market: Broad cross section of U.S. equities
• Morningstar Large Cap, Morningstar Mid Cap, Morningstar Small Cap: Broad market indexes sliced by market capitalization
• Morningstar Core Bond: Broad-based aggregate bond index
• Morningstar TIPS: Inflation-protected Treasury bond index
• Morningstar US Govt: Treasury bill index
• Morningstar Corp: Corporate bond index
• London Fix Gold: Tracks the price of gold
• S&P Global REIT: International Real Estate Investment Trust index

 

On the whole, bonds have done a great job of providing diversification for stock investors. During the last five years the broad stock and bond indexes showed a slightly negative correlation of -0.04. Corporate bonds had a higher correlation coefficient to equities (0.42) than the broader bond market. This makes sense because credit concerns for a corporation tend to affect both the equity and debt at the same time. Government debt was the most negatively correlated asset class to equities we tested. During the last five years, a decrease in the equity market generally led to a rise in Treasury prices.

But as much as bonds provided diversification to investors, there was very little diversification to be found by adding additional exposure to an asset class.

Take stocks for example. Here are the correlation coefficients for all nine sectors of the style box versus the broad index.

No matter where you invested in the style box, your returns would have been highly correlated to the broad market. That doesn't mean there aren't reasons to invest in large-value stocks versus small-growth stocks, but diversification isn't one of them.

Coefficients are lower among the various bond types compared with stocks, but for the most part, they are still fairly correlated. The outlier is the relationship between corporate bonds and government bonds. At 0.35, the correlation is fairly weak.

Gold, pardon the pun, really shined during the last three years as a diversifier to a stock portfolio. It has a near zero correlation with the equity markets and a 0.38 correlation coefficient with bonds.

Securitized real estate is often touted as a good way to diversify, but the recent correlation data doesn't bear that out with respect to stocks. The global REIT index was tightly linked with the broad market.

Now of course all of these diversification benefits only make sense in a portfolio context. Gold has low a correlation coefficient, but that is only helpful if you're also holding other asserts. Overall, the data seems to confirm that a portfolio of stocks and bonds, with room for some alternatives, is a great way to get diversification.