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Your Portfolio is Probably Not as Diversified as You Think It Is Thumbnail

Your Portfolio is Probably Not as Diversified as You Think It Is

Posted by Kevin Means, CFA on Apr 10, 2019 8:58:00 AM

Many investors try to fill in all nine of the “style boxes:” growth, core, and value along the style axis; large, mid, and small along the size axis.  Unfortunately, all nine boxes have a very high correlation to each other.  Their shared U.S. stock market risk means that they will all fall together.  To obtain meaningful diversification requires allocating to equity asset classes with much lower correlations to U.S. stocks, including real estate and international stocks.

Stock Risk Contribution to a 60/40 Portfolio is Nearly 100%

Because the volatility of stocks is so much higher than the volatility of bonds, the vast majority of risk in a classic 60/40 stock/bond portfolio is stock market risk.  Stock market risk is the risk that needs to be reduced through diversification. Bonds have a low correlation with stocks, but the expected return is also very low.  Better to use asset classes with higher returns to diversify U.S. stocks if possible.       



Diversification by Size and Style Is An Illusion 

Diversification is measured by correlation, a number that varies between -1 and +1.  A lower correlation between two asset classes means that they do a better job of diversifying each other.  Lower is better.  Too close to +1 and you are wasting your time. 

Unfortunately, the nine style boxes that so many investors focus upon are largely a waste of time.  The correlation of all that stuff is so high that there is very little diversification benefit, as shown in the graph below.



The trailing 36-month correlations of the Russell 1000 Growth Index (the most growth-oriented stocks within the 1000 largest in the U.S.) and the Russell 1000 Value Index (the most value-oriented stocks within the 1000 largest in the U.S.) with the S&P 500 are .96 and .94, respectively.  There is almost never much diversification in either of these. 

Even the small cap Russell 2000 Index (the 2000 smallest stocks after the Russell 1000) often has very limited diversification benefit.  Now is one of those times.  The current correlation with the S&P 500 is .84.

Real Estate and International Investing Offer Better Diversification

Fortunately, it is possible to find equity asset classes that offer meaningful diversification benefits for the S&P 500:  real estate and international stocks



The graph above shows five major equity asset classes that all have a much lower correlation with the S&P 500 than even small cap U.S. stocks.  U.S. and global REITs (real estate investment trusts) are a way to gain exposure to real estate, a large and important asset class with attractive return/risk characteristics.  Currently, their correlations with the S&P 500 are .68 and .60, respectively. 

Despite increasing integration among the world’s stock markets, international stocks can offer a meaningful level of diversification for U.S. stocks.  Currently, the correlation of the EAFE (Europe, Australia, and Far East) Index of developed market stocks with the S&P 500 is only .74.  Emerging and frontier markets are even better diversifiers, with correlations of just .58 and .39, respectively. 

Expected Returns Matter Too

Of course, correlations are only one consideration when selecting asset classes.  Expected returns matter more than anything else but are very difficult to forecast.  At least correlation with the S&P 500 tends to be a bit more stable, and therefore, more forecastable.  When making long-term strategic asset allocation decisions, three considerations matter most:

  1. Size—the bigger the asset class, the more important it is to include.
  2. Diversification—the lower the correlation with U.S. stocks, the better.
  3. Expected Return—the higher the better.


Indexes Used

Asset Class Index
U.S. large cap stocks S&P 500
U.S. bonds Bloomberg Barclays US Aggregate Bond Index
U.S. large cap growth stocks Russell 1000 Growth
U.S. large cap value stocks Russell 1000 Value
U.S. small cap stocks Russell 2000
International stocks (developed markets) MSCI EAFE Index
Emerging market stocks MSCI Emerging Markets Index
Frontier market stocks MSCI Frontier Emerging Markets Index
Global REITs FTSE EPRA NAREIT Developed Markets REITs Index