“Why doesn’t my portfolio always go up when the market goes up?”
By: Sam Swift, CFA, CFP®
This is a question I receive from time to time, especially when the S&P 500 has been one of the best performing asset classes as it has been recently. My first response is always to question why we’re looking at daily returns (repeat with me: daily returns are random, daily returns are irrelevant, daily returns are random, daily returns are irrelevant…), but after that it’s a nice opportunity to discuss why the S&P 500 does not represent the entire market or their portfolio. It starts with a relook at the concept of diversification.
Historically, diversification works thanks to the fact that different asset classes move somewhat independently of one another. This is a wonderful thing and runs counter to the old phrase, “There’s no such thing as a free lunch”. In order to improve a portfolio you can either raise the return while keeping the risk (standard deviation) the same, or you can lower the risk while maintaining the same return. Take the simple example of international stocks versus US stocks:
In this chart, we see that combining two risky assets can actually produce a portfolio that has a higher return and a lower standard deviation than either individual asset class which results in more total wealth.
One of the tools we use to measure the impact of an asset class’s potential diversification effects is correlation. Correlation gives us a number that tells us how likely an asset class is to move in lock-step with another asset class. A correlation of 1 means that two things move perfectly with one another. For example, watching The Notebook has a perfect correlation with me crying. A correlation of -1 means that two things move completely opposite of one another. A good real world example of this is the sleep cycles of my two dogs and my child. They match up such that one of the three is always awake and needing attention. It’s wonderful…
Most stock asset classes are much closer to a correlation of 1 than -1, but there are still significant diversification benefits. In our example above, international stocks and US stocks have a historical correlation near 0.67. Essentially, they move in a similar fashion about 2/3 of the time, but it’s that 1/3 of the time where they move differently that provides such dramatic benefits to a portfolio as we saw. Furthermore, asset classes like bonds or reinsurance have correlations near 0 with stocks which can lead to even more significant improvements.
This brings us back to the question of why our portfolio shouldn’t just look like the S&P 500. One way to analyze this is to think about global diversification as an insurance policy against poor US returns. Below is a chart that shows varying returns each year for different stock asset classes:
It’s very random year to year as to which asset classes are the best performers. Furthermore, the spread between the top and bottom can be quite large. So what happens if we just own all of the asset classes in a globally diversified portfolio? Below I’ve taken the same chart and just highlighted the S&P 500 and a global portfolio:
As you would expect, the global portfolio stays relatively close to the middle in each year while the other asset classes jump around. Looking at recent history, we can see that the S&P 500 has outperformed the global portfolio four of the last five years. This is what leads to the frustration of seeing that your portfolio isn’t up as much as the headlines said the “market” was.
On the other hand, you can look back at the early part of the 2000’s and wonder why you owned the S&P 500 at all as it was the worst performing asset class for four out of five years. This is what I mean when I refer to global diversification as an insurance policy. Owning assets other than just the S&P 500 paid off tremendously during most of the “lost decade” for US stocks. We’ll occasionally pay the price of that insurance when the S&P 500 is a relative outperformer, but it is well worth it in the long-term.
Remember that your portfolio is not just the S&P 500 with good reason, so don’t fall into the trap of expecting to track it perfectly. Correlation, or really the lack thereof, is our friend.