If you own some stocks, an emerging markets fund, and some bonds, you might think your portfolio is well diversified. But it's probably not.
You must invest in assets with low correlations. It's one of the best ways to cushion your portfolio in a crisis.
We can measure how different investments move in relation to one another... When two assets have a correlation that approaches 1, it means they move up or down together. When the correlation is low, they tend to move independently of each other. And if they have a negative correlation, they usually move in opposite directions.
Today, I'll discuss how to use this to your advantage – and one asset you should hold in your portfolio for when disaster strikes...
A well-diversified portfolio will contain a mix of assets with low or negative correlations. That way, when one asset or market falls, the other assets will hold steady or move higher to offset any potential (and hopefully temporary) losses.
If you look at the historical correlations between different markets and asset classes – like stocks and bonds – you can see this strategy works well over the long term. (Remember, a lower number means the two assets have a lower correlation.)
For example, over the past 28 years, bonds and the S&P 500 Index have a correlation of only 0.36. Meanwhile, the MSCI EAFE Index – which represents developed markets outside the U.S. and Canada – and the MSCI Emerging Markets Index have a correlation of 0.74.
You can see this in the table below. It shows correlations between several common assets and markets going back to 1988:
This is how assets and markets usually behave. But what happens to correlations when disaster strikes?
The usual trends go out the window.
During a crash, correlations between all markets and asset classes rise sharply.
This next table shows what happened to correlations during the global financial crisis (which we calculate here as stretching from November 2007 to February 2009). As you can see, the correlation between bonds and the S&P 500 rose to 0.53. Not only that, but the correlation between developed markets and emerging markets rose to a near-perfect 0.94. That's bad... because it means that these two assets would be falling in tandem.
This shows that during a financial crisis, most investable assets move in the same direction – down. Fear and uncertainty take the upper hand, and investors tend to sell everything at the same time – whether it's bonds or stocks, in developed or emerging markets.
However, one investment will do better than most should another crisis hit – gold.
Gold is great portfolio insurance. Its correlation with all of the world's major stock markets is low. In 2008 – when the S&P 500 dropped 38% and the whole global financial system teetered on the brink of collapse – gold prices climbed 6%.
In other words, a well-diversified portfolio should include gold. One good way to add it to your portfolio is to use an exchange-traded fund, like the SPDR Gold Trust (GLD). This fund holds physical gold to back its shares.
If you've been putting off adding this asset to your investments, don't wait any longer... because when disaster strikes, you'd better own gold.
Editor's note: If the recent correction spooked you, Kim's colleague Peter Churchouse has a new book that could help ease your mind and enrich your retirement. In it, he shares the secrets that made him a fortune on an overlooked asset class. Steve has called it the most important book of 2018... so important, he'll throw in a free trial of his exclusive research if you act now. Click here to learn more.
Recently, Dan Ferris shared how to identify companies that can survive – and even thrive – during a bear market. These "antifragile" businesses are a great way to strengthen your portfolio... Read more here: How to Find Stocks That Thrive in a Bear Market.
"Asset allocation doesn't guarantee returns, but it gets you closer and closer to a predictable rate of return," Dave Eifrig writes. To learn even more ways to help reduce your investing risk, check out his essay right here: The Cornerstone of Preventing Investment Worry.
Owning gold can be a great way to diversify your portfolio. And Porter Stansberry recommends adding some portfolio insurance through this gold fund...
A BULL MARKET IN 'OFFENSE' CONTRACTORS
Today, we're checking in on a theme familiar to longtime DailyWealth readers...
We're talking about defense contractors. These are the firms that supply the weapons and technology required to fight our battles. In the past, we've quipped that the U.S. is involved in so many military conflicts, we might as well call these companies "offense" contractors.
One of the top-performing companies in this sector is technology and consulting firm Booz Allen Hamilton (BAH). While the U.S. military has operated on a shoestring budget over the past decade, President Donald Trump has called for increases in military spending... And Booz Allen will benefit in a big way. Last fall, the company secured seven $100 million-plus contracts, including deals with the U.S. Army, Navy, and Air Force.
As you can see, successes like this have led to big returns for BAH shareholders. The stock is more than 80% over the past four years. And with the U.S. getting involved in more international disputes than ever before, it's a safe bet this trend will continue...