If you are interested in asset allocation, or investing in general, you should check out Wall Street Journal’s graphs showing the correlation of various asset classes with the S&P500.
There are two graphs.
The first shows a timeline from 1994-2009 showing the correlations over time. The striking feature of the graph is the rise in correlation of just about every asset class with the S&P500. For equities, it’s been increasing for several years. For bonds, it’s a more recent rise (although notice that bonds were even more highly correlated with the S&P500 in the mid-1990’s).
The second graph shows similar data, except aggregated from 1973 to 2009. It also shows the correlation of each asset class with the S&P500 for 2008. The point of the graph is the correlations became more extreme in 2008, either more positive (most asset classes) or more negative (short-term treasuries and TIPS).
The conclusion is that most asset classes become more correlated during a crisis, reducing the benefits of diversification.
Unfortunately I can only read the first 3 paragraphs of the attached WSJ article because I don’t have a subscription. It seems to conclude that asset allocation as a strategy is not effective because the correlations rise during a crisis.
I suppose there’s some truth to it if you only invest during crises. But do you know anyone that only invests during crises?
On the other hand if you plan to invest long-term, the relevant data is the long-term correlation (the grey bar on the graph) and not the 2008 correlation (the blue bar). I’m in the market long-term. I don’t care if the blue bar rises during a crisis. It’s temporary.
And there’s one more salient point. A well-thought-out asset allocation strategy, coupled with low fees/expenses and a strategic tax approach, is the only way to beat the market in the long-term that is : 1) Easily accessible to most investors, and 2) Legal.
If you abandon an asset allocation strategy, you’re left with the problem of figuring out a better strategy.
A few other points worth noticing on the second graph, going from right to left:
- The “U.S. Stock Market” to the right only shows a 0.64 correlation with the S&P500. I would have expected something in the 0.90’s given that the S&P500 is often considered “the market.” Not sure if their data is bad, or if there’s some other reason for the discrepancy.
- Hedge funds have a 0.35 correlation. This shouldn’t be news to anyone, but hedge funds are not really for “hedging.” There are half a dozen asset classes on the graph with correlations closer to zero, all of which would be better hedges.
- The emerging market stocks correlation is shockingly high at 0.99. I would have expected much lower.
- European stocks correlation is shockingly low at 0.05. I would have expected much higher, perhaps in the 0.80’s.
- Junk bonds are essentially uncorrelated to the market, making them a good hedge against general market risk.