Correlations

STOCKS FLUCTUATE MORE in value than bonds, so you can calm down a stock portfolio by adding a small position in bonds. The calming effect may be greater than you imagine. Bonds don’t just bounce around less than stocks. They could climb in value when stock prices are tumbling, especially if you own government bonds.

At issue here is the crucial concept of correlation. Most parts of the global stock market are highly correlated. In other words, when U.S. large-company stocks are in the dumps, there’s a good chance U.S. small-company shares, developed foreign markets and emerging markets are also getting hammered.

By contrast, stocks and bonds aren’t closely correlated. It’s quite possible that bonds will tread water and perhaps post gains when stocks fall in value, thus helping to offset your stock market losses and prop up your overall portfolio’s value. Similarly, you can be pretty confident that your cash investments (which are, in effect, just very short-term bonds) won’t fall in value, so they too can limit your portfolio’s losses.

This is also the promise held out by alternative investments. The hope is that, when stocks are getting trounced, perhaps your gold shares, real estate investment trusts or market-neutral mutual fund will head in the other direction.

But noncorrelated assets, whether you own bonds, cash, alternative investments or all three, aren’t just a potential source of solace during turbulent stock markets. By helping you avoid large short-term losses, they could also boost your long-run return.

Next: Measuring Volatility

Previous: Step 2: Allocation

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