Portfolio Diversification Harder to Accomplish

A buy and hold investor definitely needs investments that aren’t correlated with each other. Even investors who do some trading in their accounts want some diversification and balance. In recent years this has become harder to achieve. In the financial crisis, the correlation of all investments, except short-term treasury bonds, went to 1.0 or very close to it. That means the investments pretty much began moving up and down together. That’s changed a bit since the end of the crisis, but it’s still not back to normal.

Within the stock market, it’s tough to build a diversified portfolio. Correlations are high and seem to be rising. You can find several studies documenting this if you want to root around the web. Here’s a good one that’s easy for an investor of almost any level to follow. Rising correlations present a problem for investors who focus on fundamentals when making decisions. When correlations are high, it means investors aren’t really looking at the fundamentals of individual investments. They’re focusing on macro factors such as the global economy or latest financial crisis.

As you can see in Figure 2, the average level of stock correlation has been gradually increasing in recent years.  A number of researchers (see footnote 1 below) have pinned the rise in correlations to a market that is fixated on broad macro-economic and geopolitical issues, in addition to the record use of index derivatives, ETFs, and high frequency trading.

Figure 2: Recent Rising Correlation Trend

Source: Prima Capital, BofA Merrill Lynch US Quantitative Strategy