When crafting portfolios along the efficient frontier, investors should concern themselves with the characteristics of the portfolio as a whole and not succumb to focusing on each holding by itself.
Even very volatile investments may, in moderate amounts, reduce a portfolio’s volatility if the investment is not correlated with the rest of the portfolio’s components.
Take Chile for example. In January of 2016, we wrote an article entitled, “Why Invest In Chile?”after a three year slide in which Chile lost -45.54% of its value. But because Chile is not correlated to the S&P 500, adding some Chile to a portfolio of the S&P 500 can lower the volatility of the portfolio as a whole. And in hindsight the lowest volatility portfolio would have about 12% invested in Chile and 88% in the S&P 500.
What is true for two investment choices is also true for many investment choices. Blending an asset allocation of non-correlated assets can boost returns and lower volatility.
Hence the search to find the best non-correlated asset classes to blend with a portfolio otherwise invested like the S&P 500.
At Marotta, we track decades worth of the monthly returns of hundreds of mutual funds, exchange traded funds, and indexes looking for ways to craft better portfolio construction and hopefully optimize future returns. Sometimes we are hoping to boost returns and other times we are hoping to reduce volatility. Occasionally, you can do both.
With this in mind, I reviewed the correlation between the S&P 500 Total Return Index and all of the other components we track to see which is the best non-correlated asset for the S&P 500.
The category with the lowest correlation with the S&P 500 was U.S. Bonds of any kind. Correlations were usually negative and averaged about -0.22 within a range clustered between -0.10 and -0.45. Lowest correlation, however, may not be what you judge to be “best.”
Imagine an investment which was inversely correlated to the S&P 500. The correlation was a perfect -1.0. When the market went up, it went down, and when the market went down, it would go up. Unfortunately, if the S&P 500 averages 6.5% over inflation this inverse fund would on average go down by inflation and then go down by another -6.5%.
In addition to worrying about correlation, we also analyze an investment’s expected mean return. And adding bonds into an S&P 500 portfolio will, on average, reduce your returns since bonds have a lower average return.
The reason to mix bonds into your portfolio is to satisfy anticipated withdrawals, not to boost returns. Having some bonds in a portfolio which will be subject to withdrawals can give you a better chance of satisfying those withdrawals. If you are not withdrawing from your portfolio in the next five to seven years, then you probably should not have many bonds.
So I looked at a different measurement of the “best” non-correlated asset for the S&P 500 Total Return Index, and that is investments with a low correlation with the S&P 500 but a similar or higher mean return. Here are some great candidates along with their approximate correlation with the S&P 500:
|Approximate Correlation to S&P 500
Both publicly traded real estate investment trusts (REITs) and Energy stocks are part of the asset class we call “Resource Stocks” and which we used to call “Hard Asset Stocks.” These stocks not only have a low correlation with U.S. Stocks, but they also act as an inflation hedge and do well in inflationary environments.
Healthcare stocks tend to do better than the S&P 500 when the stock market is not doing well. They also tend to do well when the markets are doing well even though they may under perform the S&P 500 during these times. Historically they have had a lower volatility and higher mean return.
Freedom Investing and investing in Emerging Markets are not highly correlated to the U.S. Markets because they comprise investments from other countries. It is interesting that the collection of emerging market countries is more highly correlated to the U.S. Markets than single foreign countries.
Unlike investing in bonds, diversifying among stock investments does not, on average, reduce your mean return. Setting an asset allocation among stock investments and then rebalancing back to those targets can boost returns.
But diversifying among non-correlated stock investments will, by definition, mean that you will always have something to complain about. Investors want non-correlated assets until they experience non-correlation. And then, when the S&P 500 is going up and their non-correlated investments are not going up they will be tempted to sell the non-correlated assets because they are “doing nothing” and quick to buy something else which has already gone up. This chasing of returns will ruin an otherwise brilliant investment plan for the long term. Investors have to learn to be comfortable sticking to a long term plan in order to gain from non-correlated assets.
For more on this topic, I recommend reading “Diversification: Why Not Put Everything in Whatever Will Go Up the Most?” and “Nobel Prize Worthy Advice On Investing.”
Photo by Aditya Saxena on Unsplash