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If you own some stocks, an emerging markets fund, and some bonds, you might think your portfolio is well diversified. But it’s probably not.
You must invest in assets with low correlations. It’s one of the best ways to cushion your portfolio in a crisis.
We can measure how different investments move in relation to one another… When two assets have a correlation that approaches 1, it means they move up or down together. When the correlation is low, they tend to move independently of each other. And if they have a negative correlation, they usually move in opposite directions.
Today, I’ll discuss how to use this to your advantage – and one asset you should hold in your portfolio for when disaster strikes…
A well-diversified portfolio will contain a mix of assets with low or negative 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.
If you look at the historical correlations between different markets and asset classes – like stocks and bonds – you can see this strategy works well over the long term. (Remember, a lower number means the two assets have a lower correlation.)
For example, over the past 28 years, bonds and the S&P 500 Index have a correlation of only 0.36. Meanwhile, the MSCI EAFE Index – which represents developed markets outside the U.S. and Canada – and the MSCI Emerging Markets Index have a correlation of 0.74.
You can see this in the table below. It shows correlations between several common assets and markets going back to 1988:
This is how assets and markets usually behave. But what happens to correlations when disaster strikes?
The usual trends go out the window.
During a crash, correlations between all markets and asset classes rise sharply.
This next table shows what happened to correlations during the global financial crisis (which we calculate here as stretching from November 2007 to February 2009). As you can see, the correlation between bonds and the S&P 500 rose to 0.53. Not only that, but the correlation between developed markets and emerging markets rose to a near-perfect 0.94. That’s bad… because it means that these two assets would be falling in tandem.
This shows that during a financial crisis, most investable assets move in the same direction – down. 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.
However, one investment will do better than most should another crisis hit – gold.
Gold is great portfolio insurance. Its correlation with all of the world’s major stock markets is low. In 2008 – when the S&P 500 dropped 38% and the whole global financial system teetered on the brink of collapse – gold prices climbed 6%.
In other words, a well-diversified portfolio should include gold. One good way to add it to your portfolio is to use an exchange-traded fund, like the SPDR Gold Trust (GLD). This fund holds physical gold to back its shares.
If you’ve been putting off adding this asset to your investments, don’t wait any longer… because when disaster strikes, you’d better own gold.