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What a study of correlations reveals about diversification

One of the major aims of asset allocation is to craft a portfolio with ingredients that don’t all behave in exactly the same way. This low-correlation stew offers protection against all assets heading south at the same time.

But, of course, that downside protection can be a double-edged sword; the portfolio’s ingredients are also unlikely to all do well at the same time. While some of your funds will be winners, others will be relative losers.

That’s the deal with a diversified portfolio; over the long haul, it works out well, but we have to be patient in the short run.

A common sentiment heard during the 2008 financial crisis was, “All correlations have gone to 1.” While not exactly true, it was the case that correlations among a large number of asset classes increased in relation to large-cap U.S. stocks (the S&P 500) during the latter part of 2008.

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