No One Ever Made a Dime by Panicking

With the financial markets in ruin, a lot of people today seem to be asking the same question -should I take my money out of the market? My answer - not unless you have some proprietary information as to why the market is currently overvalued (which you probably don’t). For the vast majority of people I would recommend staying in the market, but being defensive with your investments. If you pull your money out of the market, you are going to miss on the potential rally. In addition to that, the stock market has historically been a great place to combat inflation (when compares to the fixed income market).  So my advice is simple - don’t pull out, diversify into uncorrelated assets.

It’s all about correlation

Diversification is not about slapping together a bunch of random stock and assets classes into a portfolio, it’s about constructing a portfolio of assets with little or, better yet, negative correlation to each other. In fact, if you are able to construct a portfolio of perfectly negative correlated assets you can technically construct a risk free portfolio with guaranteed returns. In practice however this does not work because it is very difficult to predict correlations in the future.

So how do you know what assets are correlated and which ones are not? Lucky for you there are number of site that provide such information- my favorite is www.assetcorrelation.com.

For example, the correlation matrix for US stocks over the last 182 days is:

		SPY	XLY	XLP	XLE	XLF	XLV	XLI	XLB	XLK	Return
S&P 500	SPY										-7.10%
Consumer Discretionary	XLY	0.83									-3.50%
Consumer Staples	XLP	0.21	0.63								0.50%
Energy	XLE	0.69	0.27	-0.39							-7.20%
Financials	XLF	0.89	0.85	0.26	0.41						-11.60%
Healthcare	XLV	-0.05	0.18	0.67	-0.52	-0.06					-0.60%
Industrials	XLI	0.98	0.85	0.28	0.6	0.91	0.03				-13.40%
Materials	XLB	0.9	0.6	-0.08	0.89	0.7	-0.34	0.85			-11.50%
Technology	XLK	0.91	0.68	0.16	0.76	0.64	0.01	0.87	0.88		-6.70%
Utilities	XLU	0.71	0.27	-0.34	0.94	0.42	-0.4	0.63	0.86	0.78	-6.80%

So by way of the above graph if you are heavily invested in Energy sector, then you are going to want to diversify into the Healthcare sector because of the negative correlation there between those two sectors. For passive investors who don’t want to see their gains eaten up by unnecessary fees I recommend ETF’s, which have a favorable tax structure, low expense ratio and trade like stocks.

If you want to get even more defensive with your money, which I think you should, I would recommend you diversify outside of just the US stock market into all the major asset classes.

Below is the correlation matrix for all major asset classes over the last 182 days:

		TIP	AGG	IGE	GSG	VNQ	RWX	EEM	EFA	VB	VV	VO	VGK	VPL	Return
Inflation-protected Treasuries	TIP														-4.20%
US Bonds	AGG	0.46													-2.80%
Natural Resources (Oil)	IGE	0.02	-0.19												-9.60%
Commodities Index	GSG	0.09	-0.47	0.88											-3.60%
US Real Estate	VNQ	-0.26	0.46	0.24	-0.19										0.90%
International Real Estate	RWX	0.01	0.31	0.68	0.34	0.75									-19.40%
Emerging Markets	EEM	0.03	0.09	0.86	0.6	0.6	0.94								-20.10%
Europe, Australasia, Far East	EFA	0	0.17	0.8	0.49	0.67	0.98	0.99							-16.90%
US Small Cap Stocks	VB	-0.36	0.1	0.43	0.09	0.77	0.56	0.57	0.58						0.20%
US Large Cap Stocks	VV	-0.07	0.27	0.7	0.33	0.82	0.93	0.91	0.94	0.79					-7.00%
US Mid Cap Stocks	VO	-0.11	0.09	0.83	0.52	0.69	0.88	0.93	0.93	0.79	0.96				-8.40%
European Stocks	VGK	0.04	0.19	0.77	0.47	0.68	0.98	0.98	1	0.56	0.93	0.91			-16.90%
Pacific Rim Stocks	VPL	-0.04	0.06	0.86	0.61	0.59	0.94	0.99	0.98	0.57	0.9	0.93	0.97		-11.40%
NASDAQ	^IXIC	-0.15	0.07	0.6	0.31	0.7	0.7	0.75	0.74	0.91	0.89	0.89	0.73	0.73	-4.20%

So by way of the above graph, if you only have investments in US stocks, you would want to diversify into some TIPS, US bonds or commodities.

In short, don’t pull out - uncorrelate.

TransGlobe Energy ( TGA), Uncategorized