Diversification and Volatility: What's New?

The last few months have been a roller coaster if you look at the markets through the prism of return. But what's the view if we survey the investment landscape via volatility and correlation? Has the world really changed all that much by these metrics?

Let's start with volatility, which we define as the standard deviation of monthly total returns for the trailing 36 months. Graphing that measure of risk on a rolling basis for each of the major asset classes over time reveals that the great decline in volatility in recent years remains intact, as our chart below illustrates.

Yes, volatility has in fact spiked if we calculate volatility on a daily or weekly basis. But the spikes have yet to show up in any meaningful way on longer-term measures of volatility, as you can see in the chart above. That doesn't mean that long run vols will stay low, although they might. But for the moment, the jury's still out on whether market volatilities generally have entered a new era, which is to say a higher plateau.

Meanwhile, what's the trend been for diversification of late? We're defining diversification here as correlation between monthly returns for the trailing 36 months. Looking how several asset classes stack up on that measure on a rolling basis against U.S. equities, (Russell 3000), it's clear from our second chart below that recent history is a mixed bag (1.0 is perfect positive correlation; 0.0 is no correlation; less than zero is negative correlation).

Bonds (LB Aggregate), and commodities (DJ-AIG) are still potent diversification tools relative to U.S. stocks, but less so these days than in the past. The trend of rising correlation is especially strong between REITs and U.S. stocks. Meanwhile, foreign stocks (EAFE and MSCI Emerging Markets) continue to provide slightly more diversification compared to domestic equities.

The good news is that risk-adjusted returns are enhanced by adding asset classes with less than perfect correlation to a portfolio's existing holdings. By that standard, owning a broad array of the major asset classes still makes sense. Alas, diversification isn't quite what it used to be. On the other hand, beggars can't be choosy.

Comments

[Uncle Bill]

Terrible, just terrible article. Ridiculous way to define volatility, when there are so many other ways. What's your point, to get your name in print? And why did the editors let this one thru? No aplha here.