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Figure 7 expands the analysis to encompass the worst 10 percent of calendar months for U.S. equity returns. We also shift our focus away from correlations and instead examine the return relationship from two additional perspectives. Figure 7a focuses on the percentage of months that the risk-premium asset classes experienced negative returns in conjunction with U.S. stocks, while Figure 7b shows the median returns during those same periods. Whether looking at percentage of negative months or median returns, it is clear that during the worst months for U.S. stocks, these asset classes tended to perform more similarly than simple long-term averages would indicate. And it is interesting that although the riskier assets tended to perform more similarly during the worst periods for U.S. stocks, bonds tended to perform in line with their averages.
Diversification Is Not Just About Correlation
Although most risky assets declined in value on these substantially negative days, it's important to point out that no two risky assets moved with the same magnitude. For example, on Dec. 1, 2008, when U.S. stocks returned -9.2 percent, only REITs lost more (-18.6 percent). Commodities, developed markets, emerging markets and high-yield bonds each declined, but to a lesser degree. From this perspective, these asset and subasset classes did in fact offer a form of diversification to markedly reduce U.S. equity market risk. The message is clear: When assessing the value of diversification, investors should not simply look at directional movements, particularly in the short term. Indeed, even bonds—the most common diversifier for equity risk—can move in conjunction with equities for periods of time (as we saw in Figure 2). But this does not mean that investors should abandon bonds in a long-term portfolio. The benefits of diversification, low correlation and sensible portfolio construction tend to bear out over longer—3-, 5- and 10-year—periods, even though they may not be as clear in the very short term.