Busting the correlation myth

When securities move in the same direction at the same time, that’s called correlation. If all stocks are highly correlated it doesn’t really matter what you own; all stocks rise or fall on the same fickle tide. “Everything moves together,” many complain. This is a common perception these days, but is it supported by the facts? Has over-correlation killed the markets?

In a word, I say no. You don’t have to search very far to find stocks that are not correlated. Just look at the Dow Jones Industrial Average. These 30 bellwether stocks are all large cap domestic stocks, a group generally perceived to react more or less in lockstep to economic conditions and political developments.

But they don’t.

30 stocks, 30 stories

The chart below shows 2011 total return (price change plus dividend) for the Dow components.  Twenty of the stocks had positive total returns for the year, ten negative, with a range from +34 percent to -58 percent. That’s anything but lockstep.

Even during the 2008 financial crisis when all equities – large and small, domestic and international – seemed to plunge in horrifying harmony, some stocks lost far more than others, and some simply went to zero.

It’s the same story for Fortune’s 10 Most Admired Companies, shown below. While all shared the glow of customer admiration, the companies produced very different total returns in 2011, from +34 to -33 percent:

In 2011, we also saw significant disparities between asset classes. As we discussed in a recent post, domestic stock averages were flat to slightly higher in 2011 while international and emerging markets were deeply in the red.

Non-correlation is not just a statistical phenomenon, it is the prime motivaton for diversification – holding a variety of securities within an asset class to protect against big bad one-stock surprises like Bank of America’s dismal 2011 performance. Non-correlation is also what makes asset allocation work – distributing money to asset classes with different performance characteristics to create an overall portfolio with a desired risk and return profile.

That’s why we index

Of course we do see days when all stocks seem to move together, triggered by a major interest rate announcement, foreign economic crisis or other elephant in the room. But over time, correlations vary considerably. Some stocks win; others wallow. That’s one major reason why we strongly advocate indexing. Index ETFs provide easy, low-expense exposure to dozens, hundreds or even thousands of securities within an asset class. This allows investors to earn market returns without overexposure to any single poisonous stock.

This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives.

An investment cannot be made directly in an index. Past performance is not an indicator of future results. 2011 returns shown include price change and dividends, before any investment advisory fees. Security returns are for illustration only and may or may not be held in client portfolios.