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
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
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.