Investors are exposed to financial risk in two ways: company-specific risk or market risk. Long-term investors can reduce exposure to company-specific risk by diversifying among many different securities within the same asset class. Market risk is managed, but not eliminated, by holding investments in several different asset classes.
Low Correlation: The Key to Effective Asset Allocation
Longer term, the market risk associated with an individual asset class, such as stocks, may be reduced by allocating a portion of a portfolio’s assets to other types of investments that historically have reacted differently to market and economic events. A statistic known as correlation measures the tendency of two investments to move together. A correlation close to zero indicates that two investments are largely independent of each other. The closer a correlation is to 1.00, the greater the tendency two investments have had to move in tandem. The table below lists four assets that have had relatively low correlations with U.S. stocks during the past decade. Past performance does not guarantee future results.
A Look at Correlation
|Commodities||Cash||Investment-Grade Bonds||Home Prices|
Sources: S&P Capital IQ Financial Communications; Barclays Capital. Large-cap stocks are represented by the S&P 500 Index, commodities by the Standard & Poor’s GSCI®, cash by the Barclays 3-Month Treasury Bill Index, investment-grade bonds by the Barclays Aggregate Bond Index, home prices by the S&P/Case-Shiller 20-City Composite Home Price Index.
Managing Single-Security Risk
Modern portfolio theory is founded on the assumption that investment markets do not reward investors for taking on risks that could be eliminated though diversification. A 2003 study found that at least 50 stocks may be required to provide adequate diversification for an equity portfolio.
Fortunately, there are many strategies available for diversifying a stock portfolio. Investors can allocate portions of a portfolio to domestic and international stocks, which may take turns outperforming depending on circumstances in various global economies. An allocation to small-cap, midcap, and large-cap stocks also provide exposure to companies of various sizes. Although there are no guarantees, smaller companies may be nimble enough to exploit untapped market niches and capitalize on growth potential.
In addition, equity investors looking to limit volatility may want to consider dividend-paying stocks. Although a company can potentially eliminate or reduce dividends at any time, a dividend may provide something in the way of a return even when stock prices are volatile. When evaluating dividend-paying stocks, it may be worthwhile to review how long a company has paid a dividend and whether the dividend has increased over time. According to a study by Standard & Poor’s, firms that had increased their dividends for the past 25 years outperformed the S&P 500 and also were less volatile during the 5-year, 10-year, and 15-year periods ending December 31, 2011. Past performance does not guarantee future results. When investing in dividend-paying stocks, be aware that tax rates on qualified dividends are scheduled to increase in 2013 unless Congress changes the tax laws.
For investors interested in managing volatility, asset allocation with low-correlation investments, diversification, and dividend-paying stocks may be worth considering.
August 2012 — This column is produced and is provided by The Jacobs Financial Group. (07-12)