In my slow-and-steady transformation into a cranky old man, one thing has consistently weighed on me more and more.
Naturally, at least for this evolution, or regression perhaps, it involves me being annoyed by seemingly trivial things people do.
Don’t worry, I’m not writing a screed about those damn kids and how they won’t stay off my lawn. There is a point to be made here that is useful.
Today, the target of my ire is the overuse of idioms. Specifically, how they are used as a means to cite someone smarter than you.
This proof that your haughty conversation partner has read and remembered a sentence once uttered by a famous person implies that they possess some of the famous person’s knowledge, unlike you.
Normally, this is followed up with a moment in which they feel justified in wearing a smug smile and taking a swig of their drink as they let it set in, and you catch up.
Judge them for it, I say. Taking another person’s words and appropriating them is a crutch and often a last resort.
If the quote has anything to do investing, it is even worse. It can be downright dangerous.
There Are Always Two Tides
I’m guessing by now you’ve figured out that I have a specific quote in mind. This one comes from the virtually unassailable Warren Buffett.
At a Preakness gathering attended by some other investment-minded folks, in which my unbroken streak of losing money on horses was maintained, someone I’m not particularly fond of dropped the old, “Only when the tide goes out do you discover who’s been swimming naked.”
Now, I’m sure there was some context to Buffett’s quote that was lost when it became a sound bite, and that it made perfect sense when said.
The simple fact about tides is that if everyone is in the same place, that quote is true. Yet on the other side of the world, a rising tide is lifting all ships.
What we’re talking about is market and stock correlation, and it is an issue that all investors have to face.
However, it is quite often overlooked as a threat to total real returns by retail investors.
The Game Has Changed
Now, you can make correlation measurements as complex as you want, but for the sake of simplicity, we’ll stick with looking at the 10 sectors of the S&P 500 as a proxy for the entire domestic market.
The correlation can be expressed as a percentage, but more often it’ll be as a ratio between 1 and -1. A 1 shows that the two things you are comparing move up and down together, all the time. A -1 is perfectly inverse.
Correlation between sectors averages out to about 80% right now. This actually represents a drop from 2011, when correlation went over 95%.
However, it is very far from where it was before the financial crisis. If you take a look at correlation over a much longer timespan, it averages out close to 50%.
Here is a quick snapshot of the one-year correlation ratio with the Vanguard Total Stock Market ETF (NYSEArca: VTI) as a proxy for the market, using the sectorspdr.com correlation tracker tool.
So what does this mean for us? Well, it means we have our work cut out for us. The simple concept of diversification that we all learned long ago as we just started investing, and take for granted, has changed.
Meaningful and significant diversification is more rare than it used to be, and much harder for us to build into our portfolios.
What We Can Do
There are a handful of ways to get around these issues, but there are a whole lot of factors that weigh in for the various methods to increase diversification. That means some caveats that may or may not make sense to you, your risk tolerance, or with your current portfolio.
We all know that certain assets normally have a negative correlation to stocks. Bonds, gold, and silver in particular get a lot of attention.
However all three are in weird spots. Bonds are positively correlated right now. Gold and silver just barely show a negative correlation.
In a pinch, ETFs for gold and silver will help diversify your portfolio, but not as well due to investor inflows and outflows, and the very nature of ETFs and funds in general.
That makes utilities a possibility for you, as shown above, though they tend to be debt-heavy dividend plays, which won’t fare as well if and when interest rates climb.
Commodities are a strong class of assets to consider. If you want a basket approach, there are ETFs you can use which tend to have correlations around 30% to 40%.
Precious and base metals in particular have relatively low correlations, plus buying at the lows we’re seeing now can set up large profits in cyclical assets.
Other, and perhaps the best, options are individual stocks with strong catalysts for growth or income collection.
Regardless of where you go, do yourself a favor and understand your portfolio correlation. You’ll have more peace of mind, and risk far less in a market downturn, when you do.
