River Hill Magazine: Asset Class Correlation – A Useful Tool for Managing Investment Risk

With U.S. stock market indices at or near record highs and showing increasing signs of stress, it is an opportune time to reinforce the long-term benefits of permanently including some out-of-favor positions in your portfolio.   An investment strategy practicing broad diversification can pay-off with reduced downside volatility and lead to higher long-term returns. 

A Dose of Reality

Periodic stock market corrections are an inevitable part of investing and impossible to time consistently.  Here are a few probabilities to consider based on historical data from John Tousley, Sr. Portfolio Strategist at Goldman Sachs Asset Management:

  1. There is a 57% chance for a 10% stock market correction in any given year.
  2. The probability of at least a 10% market correction increases to 65% chance when the market is trading at an all-time high.
  3. It has been 20 months (as of March, 2014) since the last 10% or more market correction.
  4. Investors who try to time the market end up underperforming by 3%.

What is Asset Class Correlation?

One-way to accomplish broad diversification in an investment portfolio is by carefully selecting different types of investments, technically referred to as “asset classes”, that have a low correlation to the stock market.  Correlation is a statistical measure of how different investments behave relative to each other.  Correlation mathematically ranges from +1.00 to -1.00.  A correlation of +1.00 indicates 100% perfect correlation and implies that a 10% gain in one asset class could be expected to also lead to a 10% gain in another asset class.

A value of -1.00 indicates perfect negative or opposite correlation.  For example, rain and umbrellas have a correlation close to +1.00.  Rain and sun have a correlation closer to -1.00.  The correlation between rain and scheduling a routine dental check-up is perhaps 0.00 and implies that these two items are uncorrelated and likely have nothing to do with each other.

The table below generated using Morningstar Principia Pro software shows the degree of monthly correlation between the returns of various asset classes for the five-year period ending 12/31/2013.  The asset classes selected for this analysis are (1) Bonds, (2) Commodities, (3) International Stocks, (4) Emerging Market Stocks, (5) U.S. Small Company Stocks, (6) U.S. Large Company Stocks, (7) Cash, and (8) Gold:

Asset Class Correlation

This analysis presents a case for including low-correlated assets including cash, bonds and gold in a portfolio to reduce the overall stock market risk of the total portfolio.  Permanently keeping a portion of your long-term investment portfolio in low-correlated investments can reduce risk and actually enhance long-term returns by helping to stabilize the downside.  On a final note, please keep in mind that correlations are not fixed and can change over time and amid different global economic conditions.

Christopher Parr is President of a local, independent, fee-only wealth management firm:  www.ParrFinancialSolutions.com

This article was written for the June issue of River Hill Magazine.