Diversification ain't what it used to be. Since 2007, there have been dramatic changes in worldwide markets. The market decline five years ago sent most assets down in unison, making it very difficult to find protection from falling prices.
Since the lows in 2009, most markets have now recovered and are considered back to normal. But there is a problem: Markets are not
back to normal.
Since 2007, there has been a fundamental shift in the relationship asset classes have amongst each other. This is a new phenomenon and is significant for a number of reasons. For one, it likely puts your portfolio at more risk than ever -- that is, unless something is done about it.
The Reasons for Diversification
The historically low level of correlations amongst assets is what made asset allocation and portfolio diversification attractive historically. Having a diversified portfolio meant your holdings were able to draw gains from certain assets when markets fell and gains from other assets when markets rallied. Generally, a diversified portfolio was supposed to provide more return, given overall risk levels.
And diversification somewhat worked, up until 2007.
Given the equity markets’ resumptions of their uptrends, one would also have expected diversification to also have returned to its “more normal” ways. But it hasn't.
A New Norm or a Warning Sign?
The historical relationship among markets has broken down, and the following data tables display the reality of the changed landscape as well as the increased risks to your portfolio.
Take a look at these two tables below, which help show the significant changes in correlations since 2007.
The first table shows the monthly price correlations between specific asset classes up to 2007. Each asset class’s data history is shown by the year in parentheses.
For example, between 1993 and 2007, the S&P 500
(INDEXSP:.INX) and oil prices had an inverse relationship, shown by a correlation of -13% circled in red, meaning that through time, their prices typically moved in opposite directions. They had no correlation and holding both in one's portfolio likely did provide some downside protection through diversification.
Now check out the next table, showing the correlation changes that have occurred since 2007. That same correlation between oil and the SPDR S&P 500 ETF Trust
(NYSEARCA:SPY) since 1993 of -13% is now shown to be 57 percentage points higher (up to 44%).
Investors now get significantly less diversification benefit by holding both of these (and most traditional) assets in a portfolio.
Every cell in the above table that is highlighted in yellow shows correlations that have risen significantly the last five years when compared to the previous time period leading up to 2007.
That is a ton of yellow, and it shows that the typical portfolio is actually likely much less protected today through diversification than it was even going into the 2007 market crash.
Do you own exposure to oil prices (NYSEARCA:OIL) along with financial (NYSEARCA:IYF) stocks? You are now significantly less diversified than the same portfolio pre-2007.
Do you own small cap stocks (NYSEARCA:IWM) along with financial (NYSEARCA:XLF) companies? That correlation has gone from 34% between 1999 and 2007 to a whopping 77% since 2007.
Taking a glance across small cap (NYSEARCA:IJR) stocks shows that adding them to your portfolio has made your diversification worse since 2007 when combined with any of the other assets except the Canadian dollar (NYSEARCA:FXC).
What About Housing?
Unfortunately it gets worse. Think the housing market is really in recovery? The very scary reality is that its correlations are also showing that the housing market is not
back to normal -- indeed it is far from it. If you own multiple homes and think that they are providing diversification because of their different locations, you should think again.
I did a similar study to the one above on the 20 major housing markets in America that resulted in a similar conclusion. That analysis shows the significant change in housing correlations. The extreme correlation among housing markets is frankly unprecedented, and troubling.
This is not normal and likely shows the recent rise in home prices is built more on speculation than fundamentals. There should be some aspect of local economies, incomes, and jobs driving housing prices, and there doesn’t seem to be any of those distinguishing factors.
Why It Matters
If you are like the typical investor and own a portfolio of sector ETFs, growth plays, and individual dividend-paying companies, you are likely adding very little diversification value by holding all of these assets in your portfolio. Unfortunately, even housing is not helping your portfolio’s diversification much either.
For one, this likely means you are overpaying in fees and commissions for diversification you are not getting. But more importantly, it could put your portfolio at as big or greater risk in another financial crisis or market decline.
Unfortunately, most people won’t care about their portfolio’s diversification until it’s too late. As long as the markets are rising, then who cares, right? But what will happen if another such financial crisis occurs?
For starters, it is safe to assume that most of these assets will only become even more correlated, just as occurred in the last crisis, and by then, it will likely be too late.
It also means that in order to find protection in such an event, investors need to look at different assets than the typical sector (NYSEARCA:XLI), REIT (NYSEARCA:VNQ), energy (NYSEARCA:XLE), or value (NYSEARCA:IWN) plays their advisor is likely suggesting.
Wouldn’t it have been nice in 2007 if investors could have known that their “diversified portfolios” would have failed them as correlations all went into extremely positive territory? Right now, those same allegedly “diversified” portfolios in reality are not nearly as diversified as they could (or likely should) be and have remained at correlation levels associated with the financial crisis, not at levels associated with historical recoveries.
Editor's note: This story by Chad Karnes originally appeared on ETFguide.com
To read more from ETFguide, see:
Is Gold Blowing Another Kiss of Death?
Stop Following the Wrong Housing Indicators
Has the US Treasury Already Exceeded the Debt Limit?