The Correlation between Correlation and Diversification
There are many limitations to correlations as a measure of diversification benefit, and chief among them is instability through time. The correlation between US stocks and bonds, for example, has oscillated dramatically between 0.6 and -0.5 over the past 15 years.1 And yet, the diversification benefit of adding bonds to stocks – reduced portfolio volatility – looks comparatively unperturbed.
The blue line in the exhibit reports the ratio of trailing three-year standard deviation values for a 60% stock/40% bond allocation relative to 100% stocks. This ratio shows the extent to which adding fixed income to equities reduces volatility. In contrast to correlation’s wax and wane, the volatility ratio has stayed consistently around 0.6. In other words, the proportional reduction in volatility gained through diversification has been largely unrelated to the estimated correlation.
Concerns about rising correlations are bubbling up again. The data say it may not be a big deal for investors
In USD. Past performance, including hypothetical performance, is no guarantee of future results.
All performance results of the hypothetical 60/40 portfolio are based on performance of indices with model/backtested asset allocations; the performance was achieved with the benefit of hindsight; it does not represent actual investment strategies. The model's performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor's decision making if the advisor were actually managing client money. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. US stocks represented by the S&P 500 Index. Bonds represented by Bloomberg US Aggregate Bond Index. 60/40 mix rebalanced monthly. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Bloomberg data provided by Bloomberg.
Footnotes
- 1Correlation measures how much stock and bond returns move together. A correlation coefficient of 1 indicates a strong positive relationship. A correlation coefficient of -1 indicates a strong negative relationship.
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