ETFs and Risk: Use Limited Correlation to Reduce Portfolio Risk - dummies

ETFs and Risk: Use Limited Correlation to Reduce Portfolio Risk

By Russell Wild

In order to put together an ETF portfolio that maximizes your return while minimizing the risk, it is helpful to understand the concept of limited or low correlation.

When the U.S. stock market takes a punch, which happens on average every three years or so, most U.S. stocks fall. When the market flies, most stocks fly. Not many investments regularly move in opposite directions.

We do, however, find investments that tend to move independently of each other much of the time, or at least they don’t move in the same direction all the time. In investment-speak, these investments are said to have limited or low correlation.

Different kinds of stocks — large, small, value, and growth — tend to have limited correlation. U.S. stocks and foreign stocks tend to have even less correlation; see the sidebar “Investing around the world.” But the lowest correlation around is between stocks and bonds, which historically have had almost no correlation.

Say, for example, you had a basket of large U.S. stocks in 1929, at the onset of the Great Depression. You would have seen your portfolio lose nearly a quarter of its value every year for the next four years. Ouch! If, however, you were holding high-quality, long-term bonds during that same period, at least that side of your portfolio would have grown by a respectable 5 percent a year.

A portfolio of long-term bonds held throughout the growling bear market in stocks of 2000 through 2003 would have returned a hale and hearty 13 percent a year. (That’s an unusually high return for bonds, but at the time the stars were in seemingly perfect alignment.)

During the market spiral of 2008, there was an unprecedented chorus-line effect in which nearly all stocks — value, growth, large, small, U.S., and foreign — moved in the same direction: down . . . depressingly down. At the same time, all but the highest quality bonds took a beating as well. But once again, portfolio protection came in the form of long-term U.S. government bonds, which rose by about 26 percent in value.

In August 2011, as S&P downgraded U.S. Treasuries, the stock markets again took a tumble, and — guess what? — Treasuries, despite their downgrade by S&P (but none of the other raters), spiked upward!

Investing in the U.S. stock market has limited correlation to investing in stock markets outside of the United States, as these five years of returns attest.

2006 2007 2008 2009 2010
U.S. Stock Market (S&P 500) 15.8 5.5 –37.0 26.5 15.1
Europe (S&P Europe 350) 33.1 15.1 –46.0 35.2 11.8
Japan (MSCI Japan) 6.2 –4.2 –29.2 6.3 15.4
Emerging Markets (MSCI Emerging Markets) 32.3 39.4 –53.3 78.5 18.9