Financial theory tells us that portfolio construction is about finding a group of assets with low correlations to one another in an attempt to find the highest return for a given level of risk. This is one of the main benefits of diversification – finding investments that zig while others zag.
This makes perfect sense in theory. The problem is when investors assume a false sense of precision when using the correlation statistic or any relationship for that matter. It would be much easier to forecast the future movements of the various asset classes and individual holdings within a portfolio if correlations were static, but they aren’t. Correlations are dynamic.
The interplay between asset classes are always changing and evolving depending on the current economic or investment cycle. And no two cycles are ever the same (seehere) which keeps things interesting.
Looking back at the long-term historical performance of stocks and bonds shows how these relationships can change over time. Here are the annual returns for the S&P 500 and 10 year treasuries by decade through the end of 2013:
Both return series are cyclical as there were periods were both performed well, both performed poorly or only one did well. Now let’s look at a fifty-fifty portfolio split between stocks and bonds over this same time frame along with the correlations from each decade and the totals:
The fifty-fifty split smoothed out the performance, but the correlation data between stocks and bonds is the interesting takeaway here. Over the entire 80+ years there was virtually no relationship between stock and bond returns (remember a correlation of zero means no relationship while -1 is perfectly negatively correlated and +1 is perfectly positively correlated).
But breaking down the performance by different periods shows that the correlation is in a constant state of flux. At times they were positively correlated. Other times they were negatively correlated. Sometimes negative correlation led to good returns while other times it led to poor returns. The same was true of the positively correlated decades.
The problem with a focus exclusively on correlation is that stocks are up on average three out of every four years. So there isn’t an investment that perfectly offsets the risk and returns from stocks with similar performance. Correlations also tend to change when high returning strategies are discovered by the wider investing community.
This doesn’t mean that statistics such as correlation aren’t useful when considering certain strategies to implement within a portfolio. It’s just that the data doesn’t really mean anything unless it’s put into the correct context. The best investors can do is put together a group of distinct factors in a portfolio with different expected risk and return profiles.
Derek Hernquist shared a quote from Charles Wheelan in a post a few months ago that was so good I had to use it again:
"Statistics cannot be smarter than the people who use them. And in some cases, they can make smart people do dumb things."
As with most investment tools, statistical relationships can be helpful to pay attention to, but investors must understand that they can change over time.
Photo: Paula Bailey
Recommended for You
NEW YORK (AP) — Consumer backlash is growing against Target's stance on what type of bathrooms its transgender customers and employees can use.Associated Press
- Advanced Direct SecuritySponsored
Monitor your home with ADT for only $9 per week including a free home security camera system (an $850 value). Get a free quote! ADT Authorized Dealer
Linn Energy (LINE) looks poised to beat analyst estimates this earnings season, with a favourable Zacks Rank and an ESP in positive territory.Zacks
These days the web is full of stories about how to massage your credit history and score to look your best to lenders. On this site and others, you’ve probably seen stories like “ 7 Fast Ways to Raise ...Money Talks News
Cramer is avoiding Ambarella but likes Discover Financial Services.TheStreet.com
- Prevention PulseSponsored
Do you eat any of these cancer causing foods? Number 12 will surprise you. Check out the list now.
Johnson & Johnson was ordered by a U.S. jury on Monday to pay $55 million to a woman who said that using the company’s talc-powder products for feminine hygiene caused her to develop ovarian cancer. The verdict, which J&J plans to appeal, was the second straight trial loss for the company, which…Reuters
The Sikorsky UH-60 Black Hawk is a workhorse for the U.S. armed forces, but the Pentagon has been looking for its replacement for more than a decade. The Army’s Future Vertical Lift program is a potentially $100 billion effort aimed at replacing the service’s entire helicopter fleet, including the…The Fiscal Times
Investor focus will remain on pipeline updates from Geron (GERN).Zacks
CNBC's Jim Cramer provides perspective on Apple's business strategy, and where the stock goes from here.CNBC Videos
Under Armour has other things going for it besides selling apparel to bankrupt Sports Authority.TheStreet.com
After months of losing the money race to Bernie Sanders, former Secretary of State Hillary Clinton outraised him by almost $10 million in April, further solidifying her status as the Democratic presidential frontrunner. Clinton, meanwhile, raised $36 million in April, with $9.5 million going to the…The Fiscal Times
- Disney Movie ClubSponsored
Get 4 Disney Movies For $1 With Membership. See Details. Exclusive Titles, Merchandise, Offers & Discounts. Plus, Free Shipping On Your Initial Order!
Harrison Scott discovered the Ridge Route in 1955. Then 18, he was out freewheeling in a brand new Ford he'd bought with a loan from his parents.Los Angeles Times
Apple CEO Tim Cook said he made a mistake by not talking about China's growing middle class when...Business Insider
- Savvy RefiSponsored
Why did no one tell homeowners about this? If you currently own a home, you better read this.
People are lulled into a sense of safety, says Bill Gates, Microsoft chairman, sharing his thoughts on problems calculating pension returns. And Berkshire's Charlie Munger weighs in.CNBC Videos
Last quarter, CenturyLink (CTL) delivered a positive earnings surprise of 23.08%.Zacks
According to John Sweeney, executive vice president for retirement and investment strategies at Fidelity Investments, you're likely to reduce or suspend new contributions during the period you're repaying the loan. Keep in mind, too, that you'll be paying the interest on that 401(k) loan with…Kiplinger
Abbott Laboratories is a bargain-priced drug firm that should greatly benefit from its rich pipeline of products and the expected decline of the dollar.TheStreet.com
Politician Donald Trump, now leading in the Republican primaries, is strongly anti-immigrant. Economic growth and employment in the United States could be improved by bringing in workers from abroad because employment is not a zero-sum game.The Fiscal Times
Two oil companies filed for bankruptcy (and more) on today's Daily Docket.The Wall Street Journal
The luxury home market may be losing some of its luster, with homes selling for $1 million or more marking their biggest decline in more than two years.CNBC