Overview

  • One goal of diversification is to build a portfolio of investments that have low correlation to each other.
  • Over the past 15 years, a portfolio invested 60% in stocks and 40% in bonds has had a near-perfect correlation to the stock market.
  • Alternatives can help lessen the correlation of a traditional portfolio to the stock market, potentially dampening the effects of market volatility.

Correlation measures the strength of the relationship between the returns of two investments and can range anywhere from +1 (perfect correlation) to -1 (perfect negative correlation). If two investments are perfectly correlated, they will always increase or decrease in value at the same time. Conversely, if two investments have a perfect negative correlation, they will always move in opposite directions.

A goal of diversification is to build a portfolio of investments that have a low correlation to each other so that not all of the portfolio's investments are moving in the same direction at the same time, particularly on the downside. While diversification strategies do not ensure profits, it can result in the portfolio as a whole having a low correlation to the broader markets, and the investor is less at the mercy of extreme volatility.

Traditional Diversification Strategies May Not Work Anymore

It used to be that a mix of small-, mid- and large-cap stocks could help minimize a portfolio's correlation to any one individual stock benchmark, for instance, the S&P 500 Index. To further diversify and reduce risk, an investor could include international stocks to broaden global exposure as well. However, over the past few decades, this option has become less attractive for investors as the correlation between U.S. and international stocks has steadily risen.1

US and International Stocks, Correlation By Decade

Bonds May Be an Incomplete Answer for Lowering Correlation to the Stock Market

Investors have long used bonds as a way to diversify a stock portfolio — often defaulting to the typical 60% stocks and 40% bonds allocation. In the past, this strategy was generally successful, yielding a sizable return with moderate risk. During the 1990s, a 60/40 portfolio returned nearly 13% a year with volatility just over 8%. But more recently this strategy has lost much of its effectiveness, with returns of about 7% and volatility increasing above 9%. During the same time, this 60/40 portfolio had a correlation of 0.99 to a portfolio that was invested entirely in stocks.1

Even Balanced Portfolios Correlate Strongly to Stocks

Alternatives Can Offer Lower Correlation and Help Reduce Volatility

The purpose of combining investments with low correlation is to provide greater diversification so that not everything in the portfolio moves in tandem. Because they tend to have lower correlation to stocks and negative correlation to bonds, alternatives can be an attractive diversifier. This can help to reduce the impact of market volatility, preserving the value of your portfolio.

Alternative Investment Correlation with Stocks and Bonds

1 Source: Bloomberg, Barclays Live. Investing involves risk. Past performance does not guarantee or indicate future results. 60/40 portfolio is represented by 60% S&P 500 Index and 40% Barclays U.S. Aggregate Bond Index rebalanced quarterly. Annualized returns based on quarterly data for each index from 1990 to 2000 and 2001 to 2011, respectively. Risk is based on the standard deviation of the quarterly return series from 1990 to 2000 and 2001 to 2011. Indices are unmanaged and it is not possible to invest directly in an index. The returns of these indices do not reflect the deduction of any sales charges or fees. The performance and risk information above reflects relative returns and risk information only for the periods indicated. Use of other beginning or ending points, or of a longer or shorter period, would result in different relative performance and risk information.

The information on this website is intended for U.S. residents only. The information provided does not constitute a solicitation of an offer to buy or an offer to sell securities in any jurisdiction to any person to whom it is not lawful to make such an offer.

Incorporating alternative investments into a portfolio presents the opportunity for significant losses. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors.

Investing in alternative strategies such as a long/short strategy, presents the opportunity for significant losses. There is also the possibility that long and short strategies could both fail, thereby increasing volatility and potential losses.

Hedge funds may not be suitable for all investors and often engage in speculative investment practices which increase investment risk; are highly illiquid; are not required to provide periodic prices or valuation; may not be subject to the same regulatory requirements as mutual funds; and often employ complex tax structures.

Utilizing private equity involves significant risks along with the opportunity for substantial losses.

Diversification and asset allocation may not protect against market risk or loss principal.

Please consider the investment objectives, risks, charges and expenses of each fund carefully before investing. The funds prospectuses and, if available, the summary prospectuses contain this and other information about the funds and are available, along with information on other BlackRock funds, by calling 800-882-0052. The prospectus and, if available, the summary prospectuses should be read carefully before investing.

Prepared by BlackRock Investments, LLC, member FINRA

* Not FDIC Insured * No Bank Guarantee * May Lose Value

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