One of the principles of strategic asset allocation is that you can reduce your risk by combining assets that have low or negative correlations. It requires the correlations between asset classes to be stable. Unfortunately, that is not the case. As a recent article in the Wall Street Journal points out:
As stocks retreated and recovered in the past 15 months, commodities investments moved in step with the U.S. market.
That wasn’t supposed to happen.
Investing in commodities long has been pushed as a useful way to cushion portfolio risk. “We haven’t seen the independence [in commodities returns] that you’d hope for in a diversified portfolio,” says Jay Feuerstein, chief executive of Chicago commodity-trading adviser 2100 Xenon Group.
This time, instead of moving independently of stocks, commodities have moved almost in lockstep with equities. The diversified portfolio you thought you built really isn’t diversified at all. To my way of thinking, this argues strongly in favor of tactical asset allocation where the portfolio is based on the current behavior of the individual components and not on some pretend correlation.
—-this article was originally published 12/29/2009. Tactical asset allocation is still a good way to deal with some of the problems created by changing correlations.