If you own some Singapore shares, an emerging markets fund, a U.S. ETF, and some bonds, you might think your portfolio is well-diversified. But it’s probably not.
I’ve talked before about investing in assets with low correlations. When two assets have a low correlation, they tend to move independently of each other. If they have a negative correlation, they usually move in opposite directions. A correlation that approaches 1 means they move up or down together.
A well-diversified portfolio will contain a mix of assets with low correlations. That way, when one asset or market falls, the other assets will hold steady or move higher to offset any potential (and hopefully temporary) losses.
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A look at the historical correlations between different markets and asset classes (like stocks and bonds) shows that, over the long term, this generally works. (A lower number means the two assets have a lower correlation.)
For example, as shown in the table below, over the past 31 years, bonds and the S&P 500 have a correlation of only 0.39. Developed markets (the MSCI EAFE Index) and the MSCI Emerging Markets Index have a correlation of 0.75.
What happens to correlations when disaster strikes?
But when there’s a crisis, the usual correlation trends go out the window. Correlations between all markets and asset classes sharply rise, as shown for correlations during the global economic crisis (which we calculate here as from November 2007 to February 2009).
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For example, the correlation between bonds and the S&P 500 rose to 0.53. The correlation between developed markets and the MSCI Emerging Markets Index rose to a near-perfect 0.94. That’s bad… because it means that these two assets would be falling in tandem.
What the table above shows is that during a financial crisis, most investable assets move in the same direction – down. That’s because fear and uncertainty take the upper hand and investors tend to sell everything at the same time – whether it’s bonds or stocks, in developed or emerging markets.
The one asset every portfolio should hold
One investment will do better than most should another crisis hit – gold. As I’ve written before, gold is great portfolio insurance. Its correlation with all of the world’s major stock markets is very low. In 2008, when the STI fell 49 percent, the S&P 500 dropped 38 percent, and the global financial system teetered on the brink of collapse, gold prices climbed 6 percent.
In other words, a well-diversified portfolio should include gold. A good way to add it to your portfolio is to use an ETF, like the SPDR Gold Trust (New York Stock Exchange, ticker: GLD; Singapore Exchange, code: O87) or the Value Gold ETF on the Hong Kong Exchange (code: 3081).