Articles

Dynamic Correlations
By Christopher Philips, David Walker and Francis Kinniry Jr.

Page 6 of 7

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.

Performance Of Risky Assets During Poor US Equity Markets

Diversification Is Not Just About Correlation
When thinking about portfolio diversification, investors instinctively focus on correlation. Yet as we have shown, combining assets with low historical correlation does not eliminate risk, because low historical correlation does not eliminate the possibility of adverse co-movement in times of crisis. Still, discussions of the benefits of diversification often overlook the fact that while assets with low historical correlation can move in the same direction, they rarely, if ever, move in the same direction with the same magnitude. Figure 8 plots the returns of the same asset and subasset classes discussed previously in this paper from October 2007 through December 2011, a period representing the entirety of the recent bear market as well as the subsequent rebound. This particular figure focuses on those days when the U.S. stock market was down 4 percent or more—significantly negative returns by any measurement. It's clear that in many of these significantly negative days for U.S. stocks, other risky assets tended to move in the same direction (similar to the correlation analysis shown in Figure 4). Ultimately, the fact that a number of risky assets declined at the same time prompted many to proclaim "the death of diversification."

Days When US Stocks Were Down 4% Or More

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.