Correlation is generally defined as “the strength and direction of a linear relationship between two random variables.” A correlation measurement ranges from -1 to +1. Ideally, an asset with a negative correlation to another is the best for diversification. Morningstar states it better by describing correlation as “a measure of the degree to which the movements of two investments are related; the higher the correlation, the more related performance of the investments.”
From a very broad sense, the best diversifier is between stock and bonds. From 1998 to 2001, the correlation between the two was -.49. This shows us that bonds were moving opposite of stock during that time frame.
I gave you that description to help explain a new report by Morningstar showing correlations of several asset classes prior to October 2007 and during the crash. We see in the chart below that diversification prior to the crash is much different than what happened during the crash. A great example is in international stocks. Prior to October 2007, the correlation to the S&P 500 was 0.57. During the crash, it moved up to 0.91, meaning that it was almost in lock step with the S&P 500. However, from 1980 to 2009, we see a correlation of 0.14. The two bright spots were Gold and Government Bonds. Both of these asset classes moved into negative correlation with the S&P 500 from October 2007 to March 2009, meaning that as stocks fell, these asset classes went up.
What we can learn from this is the magnitude of the 2007 – 2009 crash and how just about every asset class moved up in correlation to the S&P 500. By analyzing the correlation of these asset classes over the long term, it appears that we are diversified; however, during the bear market’s perfect storm of failing banks, consumer spending and government intervention, the textbook approach to diversification may have surprised many investors.