The Chinese government’s decision to devalue its currency on Aug. 5 led many U.S. investors to sell stocks, resulting in a 1,000-point drop in the Dow-Jones Industrial Average. That sudden decline also reflects investors’ fears that a trade war between China and the U.S. could hurt companies in manufacturing, retailing, and other sectors of the nation’s economy.
There are many other market forces that affect the U.S. stock market, including interest rates, likelihood of a recession, changes to corporate profitability and inflation.
But if you own real estate, either directly or through a real estate investment trust (REIT), the driving forces that affect prices are quite different. Population growth, the arrival of a large corporate headquarters or an Amazon distribution center can push up commercial real estate values in that community.
The concept of correlation: Because the prices of stocks and real estate are based on different market drivers, these two asset types have a relatively low correlation to each other. When the stock market goes up or down, the real estate assets will usually not fluctuate as much, if at all. An exception would be publically traded REITs whose shares are traded on the stock exchange.
Investors who own U.S. bonds know that decisions made by the Federal Reserve can affect the value of their fixed-rate assets changes. An increase in interest rates can reduce the desirability of a low-rate bond, and vice versa. Under most circumstances, there is a fairly low correlation between stocks and bonds. But because both types of securities are traded in the same financial market, there is a risk that bad news could lead to a sudden drop in both assets, as happened on Wall Street a decade ago.
For long-term investors seeking to protect their hard-earned assets, a portfolio that contains relatively uncorrelated asset types can reduce the risk of an unexpected decline in value. For example, many investors allocate a portion of their portfolios to certificates of deposit (CDs), money market funds or U.S. Treasury bills (T-bills). Although these assets provide relatively low returns, they are generally far less volatile than stocks and even bonds.
Consider liquidity as well: When constructing a portfolio that includes uncorrelated assets, another factor to consider is liquidity. Some types of assets, such as stocks, bonds and REIT shares, are highly liquid and can be sold at almost any time. Other assets, such as real estate properties or investments in privately held businesses (private equity), have much longer selling cycles. If you’ve ever purchased or sold your home, for instance, you know it can take weeks or months to close that transaction.
Why is liquidity important? Investors who are worried about current events can sell stocks right away, driving prices downward. But that same investor would not be able to sell real estate properties or a private equity asset immediately. Therefore, those less liquid, uncorrelated assets are much less volatile and can cushion dramatic swings in the stock and bond markets.
The current climate: Building a portfolio with uncorrelated assets can reduce the risks associated with the financial markets. This strategy also has the potential to increase returns over the long term by reducing the fluctuation in your portfolio. It can also uncover potentially undervalued assets for your portfolio.
For example, adding international and emerging market stocks to a portfolio that focuses on U.S. equities can lower correlations within this asset type. Gaining exposure to international stocks could strengthen your portfolio’s performance, since the long bull market in U.S. stocks may come to an end at some point in time.
Other types of assets with low correlations to the financial markets include precious metals, such as gold or silver, and master limited partnerships (MLPs) that invest in oil and gas pipelines and other energy-related infrastructure. Again, the drivers for these types of alternative assets are different than the forces that affect the financial markets.
When building a diversified portfolio, it’s important to talk with your financial advisor about what types of assets are appropriate for your goals and risk tolerances. Your advisor can help you review your current allocations and make any needed adjustments. Understanding the concept of correlation is one of the keys to making well-informed investment decisions.
Andrew Menachem, CIMA®, is a Wealth Adviser at The Menachem Group at Morgan Stanley in Aventura. Views expressed are those of the author, not necessarily Morgan Stanley, and are not a solicitation to buy or sell any security. The strategies and/or investments referenced may not be suitable for all investors. Follow Menachem on Twitter @AMenachemMS. International investing may not be suitable for every investor and is subject to additional risks, including currency fluctuations, political factors, withholding, lack of liquidity, the absence of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be magnified in emerging markets.