When Crunch Time Comes And Diversification Won't Help

Includes: SPY
by: Bob Johnson
One of the hallmarks of a well-constructed stock portfolio is diversification. Selections made for a balanced portfolio include large and small cap stocks, value and growth stocks, and stocks from different sectors. The idea is that these stocks will have little price correlation with each other and as some move down, others will move down less, or move up. This decreases the volatility of your portfolio and increases the SWAN factor. That is, Sleep Well At Night.
However, there is one infrequent situation where this does not work. That is when the primal herd instinct takes over, and like stampeding cattle, all the traders panic and act in unison-- like selling, with all stocks. Stampeding cattle sometimes run off a cliff; stampeding stock sellers also leap to mutual disaster. The saving graces of diversification disappear when the market panics because a temporary high correlation between stock movements takes away the leveling effect of diversification. Stocks of the S&P 500 recently moved to record high correlations as the below chart provided courtesy of Business Insider illustrates.

I do not think you will find a number showing the average correlation of S&P 500 stocks in your morning paper. Some things you might notice which could be signs of a coming lack of correlation are a great divergence between the number of stocks down compared to the number of stocks up, high volume, rapidly plummeting or rising prices and increased volume and volatility.
When the herd heads over the cliff, there may be an uncanny inverse relationship between volatility and the price drop. The VIX, a CBOE volatility index, is a widely used measure of market risk called by some the "investor fear gauge". Inverted for illustrative purposes, it is drawn below along with a graph of the S&P 500.

If you run with the herd you will be swept up and go over the cliff. If you run against the herd, you will get trampled. Move sideways and once you are out of the path of the herd, stay on the sidelines until the panic is over.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.