Key Takeaways
- True portfolio diversification depends on correlation, not allocation. Owning 20 different assets won’t protect you if they all move together during a crisis.
- Stock and bond correlations can spike during economic stress, meaning the traditional 60/40 portfolio can leave you exposed to significant financial loss.
- ETFs make it easy to build a portfolio with genuinely uncorrelated assets, like pairing bonds with commodities (-0.32 correlation) to hedge downturns.
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You can own 20 different assets and still have a portfolio that moves in lockstep without realizing it. True diversification depends on more than spreading money across different asset types. It requires spreading money across assets with low or negative correlation.
Understanding correlations can help you diversify your portfolio. For example, you can deliberately choose investments with negative correlations based on their historical performance so that when one goes down, the other goes up, thereby hedging your losses.
What Correlation Really Means (Without the Math)
Correlation describes how the performances of two investments are related. If they tend to move up or down together, it’s a positive correlation. If they tend to move in opposite directions, the correlation is negative. If there’s no relationship, there is no correlation.
Correlation is measured statistically. Lockstep moves get a 1.0 rating, opposite moves -1.0, and no correlation is represented by 0.0. All correlations fall somewhere within the range of -1.0 to 1.0.
Why Diversification Sometimes Fails
Correlation scores are only backward-looking and not guaranteed to repeat in the future. There are recent examples of spikes in correlations across assets that historically had low or negative relationships. Take bonds and stocks in 2022. While the two asset classes tend to have a negative correlation, returns on both fell in 2022.
More generally, “positive stock/bond correlations occur during supply-side economic shocks or when inflation exceeds central bank targets, prompting policymakers to adopt a more proactive monetary policy,” according to Vanguard research.
Warning
It’s not just stocks and bonds that can see historical correlations upended. During the 2020 pandemic market turmoil, many assets plunged in tandem, providing very few places for investors to find shelter.
The 60/40 Lesson: Correlations Aren’t Static
A portfolio composed of 60% stocks and 40% bonds is a common allocation strategy for those who want to grow their holdings while taking on moderate risk. However, since stock/bond correlations fluctuate, the 60/40 strategy can still leave investors unprotected in a down market.
Still, over the long run, the negative correlation holds, and most equity downturns are still accompanied by positive bond returns.
What Actually Diversifies a Portfolio
Of course, stocks and bonds aren’t the only asset classes available. Any asset types with different economic drivers, risk exposures, and investor behavior can have zero or negative correlations with each other.
When diversifying a portfolio, consider a mix of the following:
- Stocks (domestic and international equities)
- Bonds (investment-grade, high-yield, government)
- Commodities (broad basket or sector-specific: energy, agriculture, metals)
- Real estate (REITs or direct property exposure)
- Managed futures (trend-following strategies)
Since each of these asset types responds to different markets, a strategic mix can help protect your portfolio against general downturns and the occasional stock/bond correlation.
ETF Building Blocks With Differentiated Behavior
Knowing the benefits of owning uncorrelated assets is one thing. But how do you actually acquire these assets? One easy way is to purchase shares of exchange-traded funds or ETFs.
An ETF pools money from many investors to buy a basket of assets. But unlike mutual funds, shares of ETFs can be traded on stock exchanges like individual stocks.
Here are some ETF types to consider to round out your portfolio:
- Stock ETFs give you broad exposure to economic growth and corporate earnings.
- Bond ETFs can offset equities during growth slowdowns or deflationary shocks.
- Gold ETFs offer long-term diversification against real estate declines and currency debasement, with return drivers largely independent of stocks and bonds.
- Commodity ETFs help hedge against inflation and supply shocks.
| ETF Correlations | |||||
|---|---|---|---|---|---|
| Name | Ticker | SPY | IEF | GLD | COMT |
| SPDR S&P 500 ETF | SPY | 1.00 | 0.29 | 0.18 | 0.37 |
| iShares 7-10 Year Treasury Bond ETF | IEF | 0.29 | 1.00 | 0.40 | -0.32 |
| SPDR Gold Shares | GLD | 0.18 | 0.40 | 1.00 | -0.04 |
| iShares S&P GSCI Commodity-Indexed Trust | COMT | 0.37 | -0.32 | -0.04 | 1.00 |
How To Evaluate Correlation in Your Portfolio
To evaluate the correlation between different ETFs in your portfolio, research their historical behavior and economic drivers. Stocks and bonds tend to move in opposite directions, but not always. The macro situation matters.
Diversifying your portfolio beyond those two assets, with securities like a gold ETF or one that focuses on commodities like oil or agriculture, may offer more downside protection.
The Bottom Line
True diversification is about more than owning different assets. It’s about owning assets that behave differently. A 60/40 portfolio is a strong start, but when correlations spike during market stress, both stocks and bonds can fall together, leaving your portfolio unprotected.
By focusing on correlation on top of allocation, and by using ETFs to gain exposure to different asset types, you can build a well-protected portfolio. The key is understanding not just what correlations have historically existed, but why they exist and when they might break. Remember, past correlations are informative, but they’re not a guarantee.
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