Modern portfolio theory (MPT) teaches that a well-diversified portfolio is the most effective and most efficient. “Well-diversified” means we must choose asset classes that are not closely correlated with each so that when one asset class is going down, another may be going up. The simplest two asset class portfolio holds stocks and bonds.
However, in the last few years, the correlation between asset classes is decreasing, for reasons no one can really explain. For example, over the last 10 years, U.S. stocks and U.S. bonds had no correlation (a numerical rating of -0.00). However, over the last three years, these two asset classes have a numerical correlation of .30, which is considered “moderate.”
Even more alarming, over the last ten years, U.S. stocks and the stocks from developed countries outside the U.S. had a correlation of .90 (”high correlation”) and in the last three years, the correlation has increased to .93. Stocks from emerging markets had a .85 degree of correlation in the last 10 years and .87 in the last three.
When I examine correlations across all asset classes for the last three years, the same pattern emerges. In fact, every asset class I tested had at least a moderate degree of correlation with all the other asset classes.
What this means for investors is that if all your using to diversify your portfolio are the traditional asset classes, it may not be as well-diversified as you thought (or hoped) in the short run. Over the long run, only U.S. bonds showed a low degree of correlation with other asset classes. Non U.S. bonds also showed a low degree of correlation with U.S. stocks.
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