What is Proper Diversification?
Arguably the most overused word in investment jargon, diversification is not simply about holding more assets. It is about paying attention to how the different parts of your portfolio work together. It’s part art and part science, like so many things in life, and takes some careful thought to make the right choices.
Think of it like maintaining a balanced diet—one food isn’t going to give you all the nutrition you need.
Asset Classes as Food
Asset classes are your basic food groups—carbs, proteins and vegetables. As with food, each asset plays a different role.
At its most basic, you have three components: stocks, bonds and cash. Stocks are generally riskier than bonds, but you can potentially see greater gains over time. When stocks decline, bonds have generally held up better and often delivered positive returns. And then there’s cash, which many investors use to preserve capital for a major expense, like college tuition. You may want to hold a blend of all three depending on your goals.
Market Realist – Historically, stocks and bonds have moved in opposite directions.
The correlation shows to what extent one asset moves in tandem with the other. It’s important to note that +1 indicates that the two assets move in perfect lockstep with one another while a correlation of -1 suggests that the assets move in completely opposite directions. A correlation of zero means that the two assets move in random directions. This is ideal from a portfolio diversification perspective.
The graph above shows the correlation of the S&P 500 Index (RSP)(IVV), long-term Treasuries (TLT), and the Barclays Core US Aggregate Bond Index (AGG) with one another considering weekly returns in the last five years.
The S&P 500 and long-dated Treasuries move in opposite directions. They had a correlation of -0.55 in the last five years. This is because US Treasury bonds (IEF) are safe-haven assets. They perform well when equities don’t and vice versa. Treasuries cushion the impact of the vagaries in equity markets (VTI).
The correlation between the S&P 500 and the Barclays Core US Aggregate Bond Index stands at -0.3. The latter invests in investment-grade bonds including Treasuries. This is why the correlation is negative.
As we mentioned in the last part, since the correlations between stocks and bonds are rising along with volatility, it’s time to rethink your diversification strategies. Continue reading to find out how.