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Beware: Correlations Rise During Crises

Russ Koesterich, CFA of BlackRock

After the Market Crisis, Does Diversification Still Work? (Part 1 of 4)

Diversification may not have worked during the last market crisis, but this isn’t an argument for skipping exposure to international stocks. Russ explains.

If you read my recent post on why U.S. investors should consider having exposure to international stocks and you still aren’t sold on the benefits of international diversification, you may have this objection: Diversification didn’t work during the last market crisis.

This is certainly true, but it’s not an argument for staying close to home. As I write in my Market Perspectives paper, “Innocents Abroad: The Case for International Diversification,” it’s true that during the financial crisis about the only two asset classes that provided any real hedge were safe haven bonds, including Treasuries, and gold. Virtually all other risky assets moved in lockstep.

Even in the immediate aftermath of the crisis, correlations remained unusually high as investors fixated on macro events—the European debt crisis, the U.S. fiscal cliff, Greece—that transcended asset classes and geographies.

Market Realist –

Correlations rise during crises, hence reducing the effect of diversification.

The graph above shows the total returns for various assets between January 2007 and March 2009. Risky assets, including equities, had a torrid time as investors were terrified by the financial crisis. This led to the so-called “flight to safety.”

The S&P 500 (SPY)  dropped by 49.4% in that period. International stocks weren’t spared either, with international indices moving in a lockstep with each other. The MSCI Emerging Market Index (EEM) dipped by 44.0%, while the MSCI EAFE Index (EFA), which tracks stocks from developed markets other than the United States and Canada, lost 52.9%.

Meanwhile, safe havens like gold (GLD) and Treasuries, as tracked by the iShares Barclays 20+ Year Treasury Bonds ETF (TLT), gained traction as investors looked to park their funds in safe assets. Between January 2007 and March 2009, gold and Treasuries gave returns of 44.8% and 29.0%, respectively.

Remember, though, that gold prices can be quite volatile. But it’s considered safe because of its very low correlation with equities.

Even though the correlation between international equities increases during a crisis, you should still have a diversified portfolio. Read on to find out why.

Continue to Part 2

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