The curious case of correlations
Investors face a trade-off between return and stability – the more they seek of one, the less they get of the other. By investing in multiple asset classes, investors can tilt the balance of this trade-off in their favour by reducing volatility while preserving total return potential. Suppose you own an all-equity portfolio and a sudden change in personal circumstances requires you to seek more stability and forgo some growth. You could reallocate one-half of the portfolio into cash, which would cut the volatility and return potential roughly in half. Alternatively, if you invest some of that cash into bonds (the positive yielding kind, not the negative-yielding Swiss kind), which typically rise when stocks decline, you can further reduce volatility and improve return expectations at the same time – this is clearly the preferable route. When a portfolio combines asset classes that exhibit negative or weak correlations with each other, it has greater opportunities for improving risk-adjusted returns. This is why we diversify.
This notion has been challenged in recent years as the typical correlations between equities and bonds have broken down on several occasions. During the “taper tantrum” in the summer of 2013, equities and bonds sold off in tandem in response to comments by Ben Bernanke, then the chairman of the U.S. Federal Reserve, about reducing asset purchases through its quantitative easing program. We witnessed similar patterns in the spring and in August of this year when equities sold off and bonds did not come to the rescue. In each case, bonds were out of favour amid expectations of central bank tightening. This led anxious equity investors to invest in cash rather than bonds. The breakdown in correlations naturally poses a challenge for investors who rely on diversification.
Investors face a trade-off between return and stability – the more they seek of one, the less they get of the other. By investing in multiple asset classes, investors can tilt the balance of this trade-off in their favour by reducing volatility while preserving total return potential. Suppose you own an all-equity portfolio and a sudden change in personal circumstances requires you to seek more stability and forgo some growth. You could reallocate one-half of the portfolio into cash, which would cut the volatility and return potential roughly in half. Alternatively, if you invest some of that cash into bonds (the positive yielding kind, not the negative-yielding Swiss kind), which typically rise when stocks decline, you can further reduce volatility and improve return expectations at the same time – this is clearly the preferable route. When a portfolio combines asset classes that exhibit negative or weak correlations with each other, it has greater opportunities for improving risk-adjusted returns. This is why we diversify.
This notion has been challenged in recent years as the typical correlations between equities and bonds have broken down on several occasions. During the “taper tantrum” in the summer of 2013, equities and bonds sold off in tandem in response to comments by Ben Bernanke, then the chairman of the U.S. Federal Reserve, about reducing asset purchases through its quantitative easing program. We witnessed similar patterns in the spring and in August of this year when equities sold off and bonds did not come to the rescue. In each case, bonds were out of favour amid expectations of central bank tightening. This led anxious equity investors to invest in cash rather than bonds. The breakdown in correlations naturally poses a challenge for investors who rely on diversification.