Correlations They Are A Changin'

From what you have learned about what is often referred to as Modern Portfolio Theory (MPT), a diversified portfolio can significantly lower the risk of your investment. To create a diversified portfolio, you should choose assets with low correlations (covariances). However, this can be more difficult than it seems. A recent article on Bloomberg discusses how correlations between various asset classes have changed over time. For example, if you look at the 1988 to 1997 period, the correlation between the S&P 500 and the S&P GCSI Total Return Index, which measures the return on a broad class of commodities, you would find the correlation between these two asset classes was –.20, a very low correlation that would provide substantial diversification benefits. However, in the past 10 years, the correlation between these two asset classes has increased to .50, which would only provide moderate, if any, diversification benefits. We agree with the author's conclusion that even with a high correlation, owning a greater variety of assets is safer than owning only a few assets.  However, we would like to extend this conclusion and state that you should rebalance your portfolio based on the changing correlations.