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NOTE: Figures 3, 4, 5, 7 and 8 in the print version of the January/February 2010 Journal of Indexes have been modified post-publication. Please refer to the online version when viewing these figures.
Over the past two years, and particularly during the financial crisis of 2008, investors have asked many questions about their investments, including:
(1) Have the correlations for many asset classes recently skyrocketed to record-high levels near 1?
(2) Did volatility reach record-high levels in 2008?
(3) Do the widely accepted principles of diversification and modern portfolio theory (MPT) work anymore?
(4) How can investors properly diversify and manage investment risk in their investment portfolios?
In this paper, I will provide analyses of various benchmark indexes and information that could be helpful in attempts to answer these provocative and challenging questions.
Some Index Correlations Recently Hit 40-Year Record-High Levels
For the purposes of this paper, I looked primarily at the rolling one-year correlations of weekly returns of the S&P 500 Index vs. dozens of other indexes. In some of the years prior to 2008, there was evidence to suggest that some well-known stock and commodity indexes could have provided some good diversification benefits for a portfolio. For example, in the year 2003, the GSCI (commodities) Index and S&P 500 had a negative 0.38 correlation; in 1978, the MSCI EAFE Index had a negative 0.08 correlation to the S&P 500, and in 1995, the Russell 2000 and S&P 500 had a correlation of 0.53 (see Figures 1, 2 and 4). Professional investors often attempt to add asset classes with low or negative correlations to their portfolios with the goal of smoothing out the returns for the overall portfolio, and minimizing the risk of large losses, in accordance with the mandate of ERISA (the Employee Retirement Income Security Act of 1974) or other fiduciary standards.
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