NEW YORK (MainStreet) – When financial markets are jittery, many investors boost their cash holdings, a surefire way to insure against loss. But now there’s another, more subtle reason to boost cash: the high correlation between asset classes such as stocks, bonds and commodities.
Correlation is the tendency of two or more assets to move up or down in tandem. In dividing an investment portfolio between various assets, most investors seek a low correlation. That way, when your stocks dip, your bonds may rise, for example. Low correlation is the reason to diversify, or divide your eggs among various baskets to reduce the volatility of the overall portfolio.
But there’s a glitch in the system. A study by market-data firm Morningstar Inc. finds that the correlation between nine of 11 key asset classes has increased during the past 10 years, undermining the benefits of diversification.
Correlation is measured on a scale from negative 1 to positive 1. Positive 1 means the two assets are in perfect lockstep, with asset B moving up or down exactly as asset A. Negative 1 means the assets move opposite one another, so that when A rises 10%, B falls 10%.
Investors seeking low correlation want a smaller number – the closer to negative 1 the better. Unfortunately, that’s become harder to find.
Morningstar uses the Standard & Poor’s 500 stock index as the base for comparison. Druing the past 10 years, the correlation between this index and the MSCI EAFE index, which includes stocks from developed countries outside of the U.S. and Canada, has climbed from 0.47 to 0.68, increasing the correlation.
Similarly, the correlation of the Dow Jones Real Estate Trust, a gauge of real estate investments, with the S&P 500 has gone from 0.59 to 0.91. The figure for the Dow Jones UBS Commodities Trust, measuring a basket of commodities, has gone from 0 to 0.46.