Correlation is one of those things, if you were absent that day in statistics class, you should learn it now. It will help you become a better investor. As I mentioned in my previous post Asset Allocation for Retirement; I want to minimize my risks, yet maximize my returns. It sounds paradoxical, but it’s true. It’s one of the main tenants of the modern portfolio theory (MPT for short). When invested via the MPT way, your investments over the long term (20 – 30 years) get closer to what pension funds consider the average returns of 8%. When one sector zigs, I want another asset class that zags. The net effect is your investment returns are more stable. The Wall Street Journal published yesterday an excellent article on the different asset classes, and their correlation to the often benchmarked S&P 500. I suggest you read and learn from it. I would like to add a few comments of my own.
With the interactive graphs from the WSJ article, it shows what other research papers have shown and what anecdotally people have suspected. We are becoming increasingly an interconnected world. Not only with things like the Internet, cell phones and Facebook, but with commerce. The commerce that occurs in the United States affects China, as China also affects the United States. It was said at one point (as late as the early 90’s) that if you invest in the European stock market (MSCI index) that you would be somewhat insulated from shocks in the US stock market. This is definitely no longer the case. In addition, their interactive graph shows, unless you held cash 2007-2009, you took a hit on your investments. Typical investments that had either inverse or zero correlation to the S&P 500 shot up to close to 0.50 correlation. A 1.00 correlation means the asset class moves lock-step as if you invested in a single asset. A negative 1.00 correlation means it moved in the reverse direction, and a 0.00 correlation means it’s independent of the asset. Some may say this shows MPT is dead because of the correlation, and I disagree. My observations are:
The Past Does Not Equal the Future
You’ve heard this standard investment disclaimer: “Past performance do not equal future returns”. One lesson to learn from the article is to understand what once had a zero or inverse correlation, may not in the future. Stocks, no matter the country of origin are increasing becoming related. I suspect this trend will continue, but you cannot be so sure. It is a compelling argument for investing in Europe and emerging markers. However, they should be part of your total stock allocation. Other assets (like bonds) that increased correlation in the 2007-09 years, I suspect, will revert back to their long term trends. Correlation among asset classes change over time, and it’s important to understand this.
Invest in All Asset Classes
The second lesson to learn is you must not only be invested in the traditional stocks and bonds, but you should also include alternative investments. This includes real estate, commodities, and yes even buying gold. Regardless if you think gold is a bubble, there is a very strong reason to own at least a small portion in your portfolio. According to Morningstar, gold stocks have have correlation to the S&P 500 of only 0.12 – meaning almost no relation. Look at the past 10 years as an example. The DOW and S&P 500 pretty much had a net return of zero, while gold increased an average of 17% per year. During the 1990’s we all knew stocks saw unprecedented returns, while gold was negative during this time.
You Won’t Become Bill Gates
Keep in mind diversification does not prevent you from a net loss on a a daily, monthly and even yearly basis. It does help minimize your losses, and smooth out your returns for the long haul. When investing in different asset classes you hope to lose less than investing in a single asset class, but you will never make a ‘killing’ with your investments. You’ll never blow up your investments via this ‘boring’ way, but you’ll never become the next Bill Gates either. You do have some options to spice it up a little. If you feel so inclined, you can take a portion of your portfolio (no more than 20%) and take on risky investments. That way, if the investments you select blow up, you won’t be eating cat food in your retirement years. If you do make an investment and hit it big, it’s a big enough percentage to be statistically significant. What else can you can you do to strike it rich? Invest in yourself by starting a business. Typically owners have a significant portion of their net worth within their business. Since you have more control over a business you own – this is the primary method to decrease your risk, yet you also can increase your returns.