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Will a Diversified Portfolio Protect You From the Next Meltdown?

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The stock market has rebounded since the 2008 crisis and all things are back to normal on Wall Street. Meanwhile there have been some major changes to risk assets in the wake of the financial crisis that secretly keeps the risk in your portfolio elevated.

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Think you are protected from another 2008? Think again.

Your portfolio is not nearly as diversified as you think, especially if you hold the usual suspects of domestic small, mid, large, and foreign stocks.

In 2008, investors that thought they were protected through diversification were subject to larger losses than expected as correlations soared. Nothing was safe as most assets fell in value. Most advisors and strategists of course wrote it off as a one-time anomaly. Domestic stocks, foreign stocks, housing, even many bonds all lost significant value and fell together. This alone was somewhat unprecedented.

The troubling thing is this extreme correlation amongst assets still exists today. Even though markets have recovered on the upside and things are "back to normal" on Wall Street, the correlations have not reverted back to their historical (and arguably more logical) levels. As a result, risk in your portfolio is likely a lot higher than you (or your advisor) realize.

Don't Put All Your Eggs in One Basket

Correlation involves some complex math but is important because it is the primary measuring factor of your portfolio's diversification.

A correlation of -1 means the two assets move opposite each other at all times and the greatest diversification benefit exists. A correlation of 0 means there is no apparent dependence between two assets, and diversification benefit likely exists. The closer to +1 the correlation is, the higher the dependence between the 2 variables, the closer the 2 assets move in unison to each other, and the diversification benefit disappears.

A correlation closer to zero is where most asset classes were before the 2008 crisis. Many even had negative correlations. Now most sector, index, and country equity correlations remain at the upper end of the spectrum approaching +1, and that is worrisome.

Have you noticed that when European stock markets fall, so do American stock markets? When silver goes up in price so does the euro? These are all symptoms of increased correlation and are dangerous to your portfolio's diversification.

A Chart Is Worth a Thousand Words

This chart shows the Energy Select Sector SPDR (NYSEARCA:XLE) and the Financial Select Sector SPDR (NYSEARCA:XLF) ETFs from 2001-2007. The top of the chart shows the stock prices of the two with the bottom line highlighting the correlation between them through time.



The key takeaway is the correlation values and fluctuations at the bottom.

Notice, 100 day correlation ended 2007 at (-0.18) as it fluctuated in and out of positive and negative territory a number of times in the seven year period shown. A correlation in the negatives means an investor is getting some diversification benefit from holding both of the assets as their prices move somewhat opposite of each other.

A person holding Energy Select Sector SPDR and Financial Select Sector SPDR during this time period received some diversification benefit and was somewhat protected when the financial crisis started as energy stocks remained elevated and financial stocks fell during 2007 (the last year of the chart).

And Here Lies the Problem…

Once the financial crisis was in full effect, energy and financial stocks vaulted upward in their correlation…and they never came back down.

Not only did the correlation go from negative to positive since before the crisis it has skyrocketed up to 0.87.



Notice too that the correlation has not once dipped into the negative territory since 2008 and has remained extremely elevated since then, drifting at or near 1.0 for months at a time. This means there is now very little diversification protection in holding both of these indices in your portfolio.

It made sense that energy and financial companies were uncorrelated before 2007, as common logic tells us an energy company is very different from a financial company and thus the individual components that make up these indices would behave drastically different.

But, the highly correlated relationship now suggests for some reason they no longer perform that differently as investments. Energy stock index or financial company index, in reality there is very little difference between which one you choose.

This Is Just One of Many Examples

Since the financial crisis, virtually all historically uncorrelated assets remain extremely correlated. Think you are diversified because you own bank stocks and energy stocks? Think again.

Foreign versus domestic markets? Now extremely correlated.

Currencies, precious metals, even some bonds are significantly more correlated today than they were before 2008 and likely will provide little protection in the event of another high risk event, like a rogue wave (see this article).

High Correlations Are Not Always a Bad Thing

Over the shorter term, we were able to actually take advantage of the high correlation between emerging market stocks and U.S. equities on 12/2 in our Technical Forecast when the iShares MSCI Emerging Markets Index (NYSEARCA:EEM) was trading at $41.78. "A breakout of recent highs at $42.50 would be the conservative short term buy signal. Aggressive traders can buy now with the expectation of a breakout and a stop below the rising red trendline." We exited that trade one month later when the technicals warned us to take profits when iShares MSCI Emerging Markets Index hit $45.

High correlations are arguably a good thing when markets are rising since most assets will be rising together, but the portfolio risk remains extremely elevated in the event of any downside moves.

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

Guggenheim Pulls Plug on 9 ETFs

PowerShares Adds Low Vol Small and Mid Cap ETF

Will Wal-Mart Drag Down Consumer ETFs?
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