Re-thinking Asset Allocation and Correlation
A bedrock principle of asset allocation for the long term investor is asset correlation. The theory is that a properly allocated portfolio includes investments in different asset categories or classes that are non-correlated. This means that as general market and economic conditions change, the different asset classes won’t experience a lockstep change in value. In other words, you don’t want the value of all of your investments to rise and fall together, particularly the “fall” part.
There is a problem developing with practical implementation of a portfolio based on an asset non-correlation theory. The problem is that stock correlations are now ridiculously high, at 0.82. This is higher than since 1982, except for the “crash of 1987″ period. To bring even more attention to this situation, here is a recent quote from the Seeking Alpha site:
Over the nearly 40 years of data, there have only been a total of three readings over 0.80 (including the current reading) and only five reading over 0.67! Thus, the current correlation of stocks to the market is indeed quite rare.
What does this mean for the average investor? In one sense, it warns you that all of your perceived stock-picking skills may be to no avail. When a highly-correlated market falls, your picks are likely to tag along, no matter how clever you think you have been.
What can you do to respond to this situation? I’ll tell you what Mr. ToughMoneyLove has done.
First, I checked the relative correlation of our long term holdings. That is easy to do by plotting their respective market movements during the past year (or other period) on a chart. You can quickly do that displaying a Google Finance chart for one of your holdings, then use the “Compare” box to add additional investments from your portfolio to the chart.
When I did this for our ten speed “couch potato” portfolio, I observed that too many of the ten different asset classes were moving in tight correlation. This was not how it was when I first set up the portfolio in 2007.
What I did next was to reduce the number of different investments in the portfolio. I chose asset classes that were consistent with a long term “couch potato” investment plan and that were generally non-correlated. A related motivation was to make it easier to manage risk and to lower transaction costs by using stop loss orders.
If you are a long term investor, I suggest that you investigate the correlation (in today’s market) of your different asset classes. If they are tightly bound together, make a change. If you don’t, you are losing the benefit of owning different classes of investments and increasing your risk.
Or do you have a better idea to share?