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Why diversification isn’t working

Published: Nov 22, 2013 6:00 a.m. ET




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Don’t put all your eggs in one basket.

The truth behind that cliché is that some investments zig when others zag, so by diversifying you reduce your potential losses and lower your risk. That’s why Nobel Prize-winning economist Harry Markowitz called diversification the only free lunch.

But what if all the baskets were floating in the same direction, and the only one that wasn’t was filled with rotten eggs?

That’s the problem many investors face now. Risky assets, like stocks, commodities, and real estate are moving in lockstep. Only long-dated bonds are swimming against the tide, and nobody wants them because of fears the Federal Reserve will eventually stop its massive bond buying and raise interest rates.

Read Gold’s analysis of where Janet Yellen might take Fed policy .

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So, the choice appears to be throwing even more money into stocks, which are nearly five years into a bull market, or buying bonds, which we know will go down in price. Or keeping more in cash (with its negative real return) or stuffing money in the mattress. Or, God forbid, buying leveraged inverse ETFs as a “hedge.”

The problem is correlation. For those of you who, like me, snoozed through your stats classes, correlation is, according to Investopedia, “a statistical measure of how two securities move in relation to each other.”

The closer you get to a +1 correlation, the more the two securities or asset classes move together. The closer you get to -1, the more they’re going in opposite directions.

Uncorrelated assets provide real diversification. But finding them is difficult now, as you can see from the following tables, reprinted with permission of the Center for Applied Research at State Street STT, +0.21%  .

From 2003 to 2007, both commodities and 20-year Treasury bonds were the only asset classes negatively correlated with the Standard & Poor’s 500 index SPX, -0.20%  . Frontier markets and U.S. corporate bonds had only a slight positive correlation, providing some diversification.

But that’s all changed since 2008.

Correlations between the S&P 500 and all other risky assets have soared, making a mockery of research that showed investing in asset classes like commodities and real estate helped balance out your stock holdings.

According to CAR, from 2008-2012, nearly every risk-oriented asset class (global stocks, real estate, hedge funds and private equity) moved well above a 0.8 positive correlation with the S&P, and commodities weren’t far behind.

But note how 20-year Treasurys’ correlation plunged to -0.63, as close to an ideal negative correlation as you can get in the real world. Remember how Treasurys soared while stocks plummeted in 2008? Long Treasurys and, to a lesser extent, investment-grade corporate bonds became the world’s safe havens.

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