When diversified investments fall together
Joel Dresang: Paige, I want to talk with you about correlation, which measures how different investment assets relate to one another. So essentially, if something is going down in your portfolio, you want another investment that’s going up to help offset that. But sometimes even with correlation, it seems like everything’s going down together. How can that be?
Paige Radke: So, correlation is something that we use to help manage the risk in your account – so the risk of everything going down at the same time. But it’s not a risk that we can get out completely.
Correlation is based off of long-term relationships. So while that’s true, there are periods of time where typically diverse assets are moving in lockstep with one another – and that can be either up or down – but it’s important to remember that that’s typically short-lived.
Joel: So, why does that happen? Why do we have these temporary lapses in correlation?
Paige: Usually we see this when there is either an excess or a lack of fear and uncertainty. So if there’s a lack of fear and uncertainty, that’s when we start to see everything going up at the same time, but when there’s an excess of fear and uncertainty, that’s when we see things start to go down.
Take for example the terrorist attacks of 9/11. At that time, there was a lot of fear, which caused investors to be uncertain about the future, and they began to sell indiscriminately, which caused everything to go down at the same time. If we want to take a less drastic example, if you look at the start of 2018 and October of 2018, there was a heightened fear for an increase of inflation causing consumers and investors to be uncertain about the future. So once again, we saw most asset classes moving down at the same time.
Joel: So what should investors be doing during these temporary breakdowns?
Paige: They need to remember that when this does happen, it’s typically short-lived, and they’d be best to take a step back and be patient and wait for it to rebound.
Joel: So if you don’t sell the assets, you’ve only lost money on paper. But what about retirees who need to get money out of their investments for daily living expenses?
Paige: So the first thing you have to do is take a deep breath, take a step back and remember that you don’t need all of your money today.
Typically, if you are in retirement and in the distribution phase, you’re going to have cash or cash-like assets within your account that have little risk of having those big downward swings.
If you do need to make a sale, the first thing you need to do is look at your holdings and make sure that the current prices reflect the underlying value. If you’re finding that those prices are lower than you think the value is, that’s something that you’re going to want to hold on to.
Now, looking at what you do need to sell, if you’re looking around at your holdings and you’re finding that things are mostly down, consider taking a long-term perspective and looking back at the performance over the past one-, two-, or three years, and you may find that it’s your best performing asset over that time period, and still would be a viable option to make a sale.
Joel: Besides being patient, is there anything else that investors should be doing when they the correlation breaking down?
Paige: So the first thing that you should do is look at your accounts and make sure that this isn’t just temporary. So if you look back at past performance statements and you see that all of your holdings are moving up together, or down together, and to the same extent, that means that you may be lacking diversification within your account.
Joel: And then I suppose you need to rebalance your portfolio, which means using correlation again.
Paige: That’s exactly right. So that’s why in your account, you don’t just buy a stock index and a bond index to get your two different exposures. You need to construct a portfolio where you’re looking at stocks, bonds, other asset classes – as well as subcategories within those asset classes – to make sure that they’re reacting differently to different time periods. So what you need to do is construct a portfolio in which you have your holdings that are not moving in the same direction and the same extent over the long term. And if you do that and you trust the process, you should stay out of trouble.
Joel Dresang is vice president-communications at Landaas & Company.
Mind correlation to control risk, a Money Talk Video with Paige Radke
Correlation: A balancing tool, a Money Talk Video with Kyle Tetting
Efficiently allocating assets, a Money Talk Video with Steve Giles
Correlation: How investment balance can shift, a Money Talk Video with Kyle Tetting
Talking Money: Efficient Frontier
(initially posted November 27, 2018)
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