You’re not as diversified as you think

So you’ve bought a bunch of different funds and built a portfolio. You’ve got some equities, some bonds, some commercial property, and you’ve got exposure to different parts of the world. You’re diversified, right? Wrong.

Diversification is not as simple as buying different asset classes and sticking them together. What matters is how ‘correlated’ your funds are to one another. What does that mean? Simple – do your funds rise and fall together, or do they move independently?

The less correlated an asset is, the more value it brings to your portfolio. So a perfectly positively correlated asset—an asset that rises and fall exactly in line with another asset—gives no diversification benefit at all.

When you build your portfolio, you want to add in assets that are independent or likely to do well when our other assets fall.

An increasingly correlated world

Unfortunately, finding assets that are truly uncorrelated is harder in practice than it is in theory. Correlations are constantly changing. Just because something was uncorrelated in the past, doesn’t mean it will be in the future.

In a crisis, assets become increasingly correlated. In 2008, many equity, bond and property funds all suffered heavy losses at the same time, as you can see in the chart below.

Meanwhile, multi-asset funds were supposed to be well diversified and provide investors with protection when equity markets fell. As you can see below, even those with limited stock market exposure suffered large losses very quickly. These funds may have sounded good in theory, but in practice investors had little protection.

So building a portfolio that can truly protect you takes a great deal of skill. To see what I mean in a bit more detail, look at the two correlation matrix tables below.

Disappearing diversification in times of crisis

At first sight these tables look a bit intimidating, but they needn’t be. All they show is the historical correlations between different asset classes. Correlation is measured using numbers between 1 to -1.

Basically:

A correlation of 1 means the assets are perfectly correlated – i.e. they move in tandem with one another. The further we move from 1 to 0, the less correlation there is between two assets. A correlation of 0 means the asset classes are not correlated at all and move totally independently of one another. As we move from 0 to -1, the negative numbers shows a negative correlation – i.e. as one asset class goes up, the other is going down and visa versa.

The tables are colour coded as follows:

Dark blue – strongly correlated
Light blue – correlated
Green – lowly correlated
Yellow – lowly negatively correlated
Red – negatively correlated

Correlations over the past 15 years

The first table below shows the correlation between asset classes over the past 15 years. You might think this is a good barometer for choosing the most diversified assets for your portfolio; however, keep in mind this is historical data and correlations are constantly changing.

FE Analytics, IA sectors, correlation data, 03-03-2001–03/03/2016, accessed 04/03/2016.

Correlations between assets are between -1 (perfectly negatively correlated) and 1 (perfectly positively correlated). A correlation of 0 means the two assets have no correlation and returns are totally independent of one another.

Correlations during the financial crisis

Of more interest is this second table. It shows correlations during the financial crisis between October 2007 and October 2008.

Notice how the table has changed dramatically and a lot more of the table is now dark blue. This is because many assets become more correlated in a crisis. This can mean you are not as well diversified or protected as you thought.

As you can see, the correlations for many asset classes massively increased over the crisis to the point where some were almost at 1, offering no diversification benefit at all.

FE Analytics, IA sectors, correlation data, 01/10/2007–01/10/2008, accessed 04/03/2016.

Correlations between assets are between -1 (perfectly negatively correlated) and 1 (perfectly positively correlated). A correlation of 0 means the two assets have no correlation and returns are totally independent of one another.

Gold and gilts

The tables also show what may be able protect us during a crisis. Gold performed especially well, as it became negatively correlated with equities during the financial crisis. This highlights its particular use as a diversifier in turbulent times, versus its low level of correlation over a longer period.

UK Gilts also held up well, as they remained uncorrelated. Absolute return funds are not included in this table, but they also have the potential to offer protection as long as we select the right funds. And we shouldn’t forget the value which holding cash can have in times of crisis.

The key takeaway is not to take your diversification for granted. We live in a globalised world where actions have far reaching consequences.

This isn’t to say that you shouldn’t have exposure to different parts of the world or different assets. You should. Just be aware of the limitations, be aware how much risk you want to take and what will really protect you in a true crisis.

This post is amended from a FundCalibre blog originally published on Mindful Money, 30 March 2016.