Investors understand that correlations jumped across the board during the liquidity crisis, and some are now asking whether that means that they should exit any of their high-return asset classes because of higher correlations with the U.S. stock market.
That’s not how investors should think of correlation. A low correlation between two high-return asset classes means that we can invest more into BOTH of those asset classes without increasing the volatility of our overall portfolio. An increase in the correlation means that, in order to keep down the volatility of our overall portfolio, we must put more of our portfolio into low-return, low-volatility assets (such as Treasuries or other low-risk bonds) and reduce our exposure to BOTH high-return asset classes—not that we should keep one high-return investment and exit the other.
Over the long run, the correlation between domestic stocks and publicly traded domestic REITs—which enable investors to access the real estate asset class through the stock market—has been only around 50%, which meant that savvy investors could allocate significant shares of their portfolio to BOTH stocks and REITs without driving up their overall portfolio volatility. During the market crisis, the REIT-stock correlation went up to about 71%, but that’s still low enough to keep substantial allocations to both REITs and stocks. (My own portfolio, for example, now has 46% in stocks and 37% in REITs.)
In general, any optimally diversified investment portfolio will include substantial allocation to both of the high-return fundamental asset classes—stocks and real estate, accessed through publicly-traded REITs—along with the low-return fundamental asset classes (bonds and cash) and perhaps some high-return but non-fundamental assets such as commodities. The increase in correlations may have prompted investors to de-emphasize the higher-return asset classes, but they should not change that basic approach—and, when correlations return to long-run norms (as I believe they will), investors will want to return to their original emphasis on higher-return asset classes.
Disclosure: Author is long ING Real Estate Fund and Vanguard REIT Index Fund.
Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.
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