Adding an array of asset classes to your stock allocation can sometimes provide ballast for your portfolio, similar to how a keel keeps a sailboat afloat. Diversification can also reduce the overall volatility of the stock portfolio.
Central to this concept is the correlation among asset classes i.e., the measure of how different securities tend to move in relation to each other. In theory, by mixing low-correlated asset classes with your stock allocation, you can reduce portfolio volatility.
To have the greatest asset-allocation benefit from mix of two asset classes, the asset classes would have a correlation of -1 , meaning they tend to move in the exact opposite direction of each other. A positive correlation of 1 between two asset classes would therefore provide no reduction in portfolio volatility, as they would generally move in tandem.
To understand the realities of asset class correlations, let’s look at long-term and short-term correlations during the 2008 financial-market meltdown usinq four exchange-traded funds, or ETFs, for the stock, bond, gold, and commodity asset classes.
Mixing stocks with bonds traditionally has provided the greatest asset allocation benefit of reducing volatility over long-term periods.
However, the real-world asset allocation dynamics during the 2008 financial markets meltdown were much more variable. Between September and October of 2008, correlations spiked, asset classes moved down in sync, diversification failed, and strategic asset-allocation portfolios dropped more than expected.
The following table details the corresponding returns during this critical period.
Therefore Commodities and Gold do not provide the diversification benefits when protection is critically needed during a stock market meltdown. However bonds appear to do the best.