Don't look now, but asset correlations have been rising again. While asset correlation is normally only a subject that would interest the true finance and math nerds among us, it has a very real impact on the regular investor's portfolio. In particular, it threatens the very heart of diversification and investors who believe themselves to be insulated from bad markets by a broad portfolio may be in for a very rude surprise. (For related reading, also see Top 5 Signs Of A Credit Crisis.)

TUTORIAL: Economic Indicators To Know

What is Correlation?
Correlation is basically a mathematical measure of the extent to which two variables "move together". If Stock A moves 5% and Stock B moves 5%, the correlation is 100% (or 1.0). If there is no apparent linkage between the move of Stock A and Stock B, the correlation may be zero, and in some cases there can be negative correlation (as one goes up, the other goes down).

Correlation is the key concept underlying portfolio diversification. If an investor holds a portfolio of nothing but technology stocks, it stands to reason that they will be very vulnerable to the state of the technology market. If you add some Treasury bonds or gold to the mix and suddenly the picture changes - the diversified portfolio will not go up as much when tech stocks are on fire (because some of the assets are in bonds and gold), but if tech stocks weaken the portfolio can be expected to outperform because the gold and bonds will move differently.

In other words, much of the advice that investors get about how to build a portfolio - own mutual funds, own some international stocks, own some bonds, own a little gold - is all predicated on these correlation relationships and the idea that different assets respond differently throughout the market cycle.

The Dark Days
In normal times, there is relatively little correlation between stocks, bonds, gold and significantly less correlation between domestic and international categories and so on. When times get rough, though, those correlations change dramatically.

As fear takes hold and investors panic, risk dominates trading and correlations soar. During the worst of the credit crisis, correlations spiked and approached one in many cases. Hedging strategies collapsed as historical correlations fell apart and investors realized that they had much greater risk of loss than they thought. This, in part, is how the crisis spiraled out of control - investors had a false sense of security going in (based on the assumption that past relationships would stay consistent), levered up, and then watched in horror as the losses piled up in defiance of their model.

Why does this happen? When fear hits the market, many investors pull the ripcord and try to go to cash or cash-like instruments. That creates tremendous selling pressure across all assets. At the same time, there are margin calls and stop losses exacerbating the selling and a great deal of wealth destruction going on. In other words, it's all selling and no buying - a condition that further pushes those correlations towards one (since everyone is trying to sell) and further devalues diversification.

Some market observers have tried to place the blame for this phenomenon on the growing influence of ETFs. That idea has a lot of merit up to a point - it is certainly true that ETFs manage a great deal of assets today and institutional investors use them almost as "instant diversification" options. It is also worth noting, though, that this effect is also a byproduct of the increasing ties between countries and the similarity of investment approaches - if everyone is making the same decisions on the same information, those diversification benefits dry up.

TUTORIAL: Top Stock-Picking Strategies

Here We Go Again?
Investors should take note of the fact that correlations are moving up again. A recent report from ConvergEx highlighted that the average correlation between equity sector ETFs and the S&P 500 is now above 97% - up from 82% three months ago. Correlations with emerging markets and high-yield bonds have likewise increased significantly and recently there is little difference between owning U.S. stocks, international stocks or high-yield bonds.

In the meantime, the correlation for precious metals like gold and silver are shifting significantly as well - before the recent plunge in metals the correlations had actually gone negative to a meaningful degree. While precious metals typically show very low correlation with equity markets (and many market observers think the long-term correlation should be close to zero), those relationships can spike rapidly during market panics. Gold actually did not perform well through large stretches of the credit crisis. This is an important point - gold is NOT supposed to move opposite of stocks, it's supposed to move independently of them. Consequently, investors who think that holding gold will protect them from a big drop in the market may be in for a nasty surprise.

In plain English, this means that there are fewer places to hide and fewer ways to make money. Moreover, the globalization of the financial markets has increasingly meant that "their" problems are now "our" problems - if major banks in France or Germany fail, it won't matter much how many health care or consumer staple stocks a U.S. investor holds. Likewise, a weak economy in Europe or high inflation in China is ultimately bad news for us as well.

The Bottom Line
Rising correlations should not lead people to abandon the idea of diversification. Correlations are often mean-reverting numbers. High correlations today will probably reverse again to low correlations in the not-so-distant future. So over a long term investment horizon, the arguments for diversification still make a lot of sense.

What investors should remember, though, is that markets do panic from time to time and when that happens the conventional rules fall apart. That is not an argument for abandoning portfolio diversification, but it is an argument for not getting too cocky in thinking that a balanced portfolio is proof against market losses. Understand that periodic freak-outs are part of the market and that calm investors sticking to sound strategies can use these times to buy good assets at great prices. (For additional reading, also see Diversification Beyond Stocks.)

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