3 assets that may not diversify as well as you think

Diversification is a core principle of sound investing: A portfolio that includes assets with different performance characteristics often leads to better risk-adjusted returns than one that relies on a single asset class.

But building a diversified portfolio can be easier in theory than practice, as many asset classes often touted as good portfolio diversifiers may not live up to their reputation.

Real estate

In some past periods, real estate investment trusts didn’t move closely in tandem with the broader US equity market.

Rolling three-year correlations have dropped as low as 0.10 during some periods, such as the early 2000s. And being untethered to the overall equity market can lead to better risk-adjusted returns when real estate is added to a diversified portfolio.

In recent years, however, real estate has generally moved more in line with stocks overall. This has also made it a less valuable cushion against bear-market declines.

Real estate had previously held up better than the overall market during some market corrections, such as the tech-stock correction that started in early 2000. But during the three most recent bear markets, real estate suffered heavier-than-average losses.

High-yield bonds

High-yield bonds (also known as junk bonds) are issued by corporations with below-average credit ratings, generally defined as BB+ or lower from a major credit rating agency.

As a result, they tend to trade more in line with broad credit markets, overall economic trends, and company-specific factors than they do with Treasuries. As a result, they’re less sensitive to interest-rate movements than investment-grade bonds, which means they can provide diversification benefits within the bond portion of a portfolio.

At the same time, though, high-yield bonds have a relatively high correlation with stocks. They typically suffer during periods of weaker economic growth, which are also negative for stocks.

Granted, high-yield bonds have historically provided some protection from market drawdowns. However, Treasuries have done a much better job of cushioning downside risk.

Cryptocurrency

As an asset that exists purely in digital form, cryptocurrency is fundamentally different from other major asset classes.

Bitcoin still accounts for most of the investor interest and assets, but numerous digital currencies have also attracted more attention from both retail and institutional investors over the past couple of years.

As a nontraditional asset, cryptocurrency has had an extremely low correlation with most other major asset classes.But there are two reasons crypto may not make the best portfolio diversifier.

First, as digital assets have attracted more interest from mainstream investors, correlations have steadily trended up in recent years.

Second, crypto’s potential diversification value has been overshadowed by its extreme performance swings. Instead of acting like a noncorrelated asset, digital assets are mainly defined by their extreme volatility. Over the past three years, bitcoin has been nearly 4 times as volatile as stocks. Much of this volatility has been on the upside, but bitcoin and other cryptocurrencies have also been subject to extreme drawdown risk.

Takeaways

The three examples discussed above underscore two of the limitations of correlation metrics. First, correlations can change over time, meaning that assets that were once great diversifiers may no longer be so. And second, even assets that still have a relatively low correlation coefficient may still be subject to above-average downside risk.

This article was provided to The Associated Press by Morningstar. For more personal finance content, go to  https://www.morningstar.com/personal-finance