Diversifying across asset classes (otherwise known as asset allocation) is the foundation on which prudent, long-term successful investment strategies are built. One of the essential issues for allocating among the various asset classes is carefully choosing those pieces that will offer the most diversification bang for the buck, and then weighting the asset accordingly. Modern portfolio theory advises that there are three primary variables that feed into this decision: volatility of returns, expected returns for each asset, and the correlation of returns among the assets.
Focusing on the latter for the moment reveals several interesting trends for the strategically minded investor. (We’ll be publishing more on correlations going forward, but for the moment here’s a taste of what we’re tracking.) Let’s start with the classic stock/bond mix, for which we crunched the data based on rolling 36-month trailing correlations for monthly total returns between the Russell 3000 and the Lehman Aggregate Bond Index, plotted monthly, starting in January 2001 and running through last month.
As the chart below reveals, the sharply negative correlation that defined equities and fixed-income in recent years is giving way to something less. To be sure, stocks and bonds still post slightly negative correlation, and so the diversification factor remains potent for owning both asset classes. But if the trend in recent years keeps up, investors may want to re-examine diversification expectations for the classic stock/bond mix. (Note: 1.0 indicates perfect correlation, 0 is no correlation, and -1.0 is perfect negative correlation).
