If you are making money on everything in your portfolio -- watch out!
As I study portfolios, I believe very few people are prepared for a downward move in the world equity markets. Mark my words, in 25 years of managing money, I have never been more convinced that we are on the be brink of a rough equity market. Most investors are ill-prepared and have not learned from the liquidity crisis. A properly managed portfolio is like the military -- always prepared.
A portfolio that is making money on everything at the same time is poorly constructed. A properly managed portfolio should always have some investments that are not doing well. If all of your assets are going up together you should be concerned because when the positive economic condition changes, you need to have some investments that can go up. Financial advisors and clients need to do a better job of protecting portfolios against a downward move in the world stock markets. It is virtually impossible to manage a portfolio today without having non-correlated assets in the portfolio. Due to computer systems and communication systems, most asset categories have become highly correlated. When the markets are going higher, people don't seem to care because generally speaking, most investors are owning investments that are very similar. However, when the positive economic events that cause these assets to go higher changes, everything in their portfolio will drop simultaneously. Prior to the mid-eighties, you could effectively have a portfolio that consisted of US stocks, international stocks and bonds and still have a low risk and well diversified portfolio. However, in recent years, this type of portfolio would not be considered broadly diversified. if you understand correlations, you can protect your portfolio and your "nest egg" from a sudden drop due to any of the negative probable outcomes that are on the horizon today.
We measure the correlation relationship between two assets as between plus 1 and minus 1. If two assets have a high correlation (0.85 or higher) this means that they generally move up and down together.
Today, 94% of all equity categories ranging from large cap growth and value to micro cap, from utilities to MLPs, from MSCI/EAFE to frontier markets are so highly correlated that it is difficult to reduce risk by simply investing in these. The following table shows timed correlations for the past 20 years.
Bottom-line, advisors and clients need to study the correlation of assets and be ready for what I believe to be an inevitable downward move in the world markets.
Ed Butowsky is an internationally recognized wealth manager. His upcoming book titled "Are You Committing Financial Suicide?" is expected to be released this spring.