The Asset Allocation Pragmatist

Adding an array of asset classes to your stock allocation can sometimes provide ballast for your portfolio, similar to how a keel keeps a sailboat afloat. Diversification can also reduce the overall volatility of the stock portfolio.

Central to this concept is the correlation among asset classes -- i.e., the measure of how different securities tend to move in relation to each other. In theory, by mixing low-correlated asset classes with your stock allocation, you can reduce portfolio volatility.

To have the greatest asset-allocation benefit from a mix of two asset classes, the asset classes would have a correlation of -1, meaning they tend to move in the exact opposite direction of each other. A positive correlation of 1 between two asset classes would therefore provide no reduction in portfolio volatility, as they would generally move in tandem.

To understand the realities of asset class correlations, let's look at long-term and short-term correlations during the 2008 financial-market meltdown using four exchange-traded funds, or ETFs, for the stock, bond, gold, and commodity asset classes.

Since April 2007, the average 12-month correlations of the Vanguard Total Stock Market Index ETF (VTI +0.34%) with the Vanguard Total Bond Market Index ETF (BND +0.20%), the SPDR Gold Shares ETF (GLD 0.25%), and the iShares S&P GSCI Commodity-Indexed Trust (GSG +1.96%) were as follows:

• Stocks and bonds: -0.34. Therefore if stocks fell 10% over the period, then bonds would increase 3.4%.
• Stocks and gold: 0.13. If stocks fell 10%, then gold would fall 1.3%.
• Stocks and commodities: 0.72. If stocks fell 10%, then commodities would fall 7.2%.

Mixing stocks with bonds therefore appears to provide you the greatest asset-allocation benefit of reducing volatility over long-term periods.

However, the real-world asset-allocation dynamics during the 2008 financial markets meltdown were much more variable. Between September and October of 2008, correlations spiked, asset classes moved down in sync, diversification failed, and strategic asset-allocation portfolios dropped more than expected.

Here are the correlations between stocks and other asset classes during the meltdown:

The following table details the corresponding returns during this critical period.

Month-to-month correlations between stocks and other asset classes can vary widely and increase significantly during a financial crisis. The only panacea to protect your assets during a financial-market meltdown in which stocks, bonds, gold, and commodities are falling together is an allocation to the cash asset class.