Is Your Portfolio Really Diversified?
Thomas M. Geier, CPA, CFP®, PFS
The cornerstone of diversification is a mixture of investments, each of which has broadly differing patterns of strength and weakness. That way, strengths in one investment can potentially offset weaknesses in another at any given time. The greater the difference in performance patterns of any two investments, the bigger the potential benefit from diversification.
Historically, alternative investments such as real property and precious metals provided a non-correlated counterbalance in portfolios to traditional holdings such as stocks.
Over the past decade, some investments that once differed significantly began performing more alike and this reduced their potential to offset each other’s ups and downs in your portfolio. As financial instruments and global markets became increasingly liquid and accessible, different asset classes became more closely interrelated.
Correlation Is Important
Correlation is a common measure of the variation in performance between two investments—the lower the correlation, the greater the potential to diversify your holdings. A correlation of zero denotes no statistically measurable relationship between changes in one set of returns and changes in another. In other words, the less alike two investments are, the less likely they are to both drop in the same market conditions.
But investors need to remember that different asset classes that once tended to correlate at a relatively low level, might have increased in correlation in recent years, so it’s important to review diversification and correlations at least yearly.
Be Careful of So-Called “Rules”
One of the most often-cited diversifications “rules” from investors is the relationship between stocks and bonds. This “rule” states that when stock prices go up, bond prices go down, meaning stocks and bonds have an inverse relationship.
Logically, one can see how many might arrive at this “rule” because one might think that investors essentially chose between risky, high-return potential of stocks or the safe, relatively low-return potential of bonds. And since investors must sell one to buy the other, bond prices tend to drop when stocks are rising and vice versa, right? Well, as logical as that might actually sound, the exact opposite has occurred on many occasions—stocks and bonds have actually have risen and fallen in tandem.
The fact is that stock-bond correlations have not always been negative. In fact, over the long-term, stock-bond correlations average roughly zero. In recent times, however, there have been two fairly distinct periods—from the 1980s through the tech bubble, stocks and bonds were somewhat correlated, and since 2000, stocks and bonds have tended to move in opposite directions.
Sources: eMoney ABM.
© Geier Asset Management, Inc. Oct 2018. Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance.