Table 2 (above) goes into more depth around the data set chosen for this study — it indicates the differences in the five year correlation coefficients and the twenty-five year coefficients. That is, if two assets were correlated perfectly (1.00) over the last five year period and only 0.75 correlated over the last twenty-five year period, the chart would read 0.25 (1.00 minus 0.75). The positive numbers in the graph indicate by how much two assets have become more correlated over the last five years versus the last twenty-five years; the negative numbers the reverse.

Notice in Table 2 that all asset classes, except Investment Grade Bonds, have become to some degree more correlated over the last five years than they have been over the last twenty-five. Given what we know about the world this should come as no surprise. What is surprising is that most investment advisors continue to use outdated historical data while attempting to optimize portfolios for clients.

Table 3 (right) illustrates how differently asset classes as a whole have behaved during past bear markets. As you can see during the bear markets of 1990 and 2000-2002, asset class returns varied greatly. For example in 2000 and 2001 three asset classes achieved positive returns for the year and five were negative. Additionally, the range of returns in negative returning asset classes was quite wide in all years of the prior two bear markets.

Correlation of Asset Classes

Juxtapose these facts to those of the most recent 2007-2009 bear market (which primarily occurred during 2008) and the data clearly supports the theory that asset classes are behaving more alike. During the 2008 decline only one asset class (Investment Grade Bonds) achieved a positive return for the year of 5.24%. All other asset classes had negative returns and all of these asset classes returned less than -28.92%.

What we can conclude from the data in Tables 1, 2 and 3 is that virtually all asset classes are becoming more correlated and that returns are not only unstable, but that they evolve radically over time. This creates a unique challenge for a money manager — strategic asset allocation can only be as effective as the manager who understands the data that goes into the model. Designing properly diversified investment portfolios has become increasingly difficult and we no longer can rely on traditional asset allocation methods. SimonDavis is on the cutting edge of progressive portfolio construction.