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
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
(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
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,
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
Why It Matters
If you are like the typical investor and own a portfolio of sector
, 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
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