Guest post by Larry Swedroe, co-author of Investment Mistakes Even Smart Investors Make.
Prudent investors build portfolios that include asset classes that have low correlation. Values can range from +1.00 (perfect correlation) to 1.00 (perfect negative correlation). Positive correlation means that when one asset produces above average returns, the other tends to also produce above average returns. Conversely, negative correlation means that when one asset produces below average returns, the other tends to produce below average returns. Thus, the lower the correlation of returns, the more effective the asset class is as a diversifier of portfolio risk. Note the relatively low annual correlations of some of the various asset classes to the S&P 500 Index for the period 19882010.
Based on these historical relationships, investors expect that while all asset classes will do poorly from time to time, the non-perfect correlations of the various asset classes will prevent them from all doing poorly at the same time. Unfortunately, investors make the mistake of not putting enough emphasis on the key words, tends to.
Knowing the history of returns would have prevented investors from misunderstanding the benefits of equity diversification. The latest financial crisis revealed nothing new about correlations. The systemic risk of equities showed up when the financial crisis that began with U.S. housing prices falling sharply spread around the world in the summer of 2008. Every major equity class experienced a dramatic bear market. In some cases, it was the worst since the Great Depression.
Most of the time, risky asset classes do not exhibit very high correlation. And many have low correlations. However, in times of global crisis, all risky assets tend to correlate highly. And that leads us to the important lesson the markets teach us.
In times of crisis, the only effective diversifier of equity risk is high quality fixed income investments, the safest of which are obligations that carry the full faith and credit of the U.S. government. During this crisis, while all equity asset classes were experiencing severe bear markets, U.S. Treasury instruments were providing positive returns.