Increased correlation: A challenge
to diversification

Correlation measures the strength of the relationship between the returns of two investments. It 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. While diversification does not ensure profits, it can result in a portfolio with lower correlation to the broader markets, leaving an investor less at the mercy of market extremes.

Rethinking traditional
diversification strategies

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. However, over the past few decades, this approach has become less attractive as the correlation between U.S. and international stocks has steadily risen.

U.S. and international stocks, correlation by decade

US and International Stocks, Correlation By Decade

Bonds may be an incomplete answer

Investors have long used bonds as a way to diversify a stock portfolio — often defaulting to a 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 14.14% with volatility of 9.00%. But more recently this strategy has lost some of its effectiveness, with returns of only 6.44% and volatility edging up even further to 9.06%. 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 correlated strongly to stocks

Correlation of a 60/40 portfolio to other risk sources over the past 10 years1

Chart: Even Balanced Portfolios Correlate Strongly to Stocks

Alternatives: A closer look
at correlation

Because alternatives tend to have lower correlation to stocks and low-to-negative correlation to bonds, they can be an attractive diversifier. This characteristic can help to reduce the impact of market volatility, smoothing returns during turbulent periods for traditional investments.

Alternatives: Correlation to stocks and bonds (2007-2016)

Chart: Correlation to stocks and bonds