Diversification and correlated markets

papisito

Hi

I'm a newbie investor.

70% of my investments are in cash or equivalents right now. The other 30% is in equity via funds. I'm aiming to eventually have a 30/70 cash-to-equity split.

As all the good advice goes, I'm trying to get my 'asset allocation right' whilst keeping my charges at a minimum. My 30% is currently made up of 1 FTSE 100 tracker, 1 emerging market tracker and 1 emerging market managed fund.

Obviously I need to diversify this as it's very biased towards emerging markets. Using MorningStar's excellent X-Ray tool it shows I have little exposure to the developed markets, particularly the US - so that seems like a natural next fund to buy as I continue to set my building blocks.

However, if you look at the performance of the FTSE 100 against, for example, HSBC's American Index which tracks the S&P 500, it shows an almost exact correlation over the last 5 years. If this is the case, I see no point in diversifying into a correlated market like this, because if one market is going down the other is very likely to be going down too, so how have I spread my risk?

To me the answer is I haven't and I would be better off diversifying into a non-correlated territory/asset/sector.

Would someone care to challenge my thinking?

P

WHITEVANMAN

However over the next 5 years, the difference between the U.K and U.S reactions to deal with the financial crisis may widen somewhat.

StevieJ

papisito wrote: »

However, if you look at the performance of the FTSE 100 against, for example, HSBC's American Index which tracks the S&P 500, it shows an almost exact correlation over the last 5 years.

What about exchange rate considerations, depending on when you invested, say 2007 you may have seen a 25% out performance purely on the Stg/Usd rate dropping from 2 to 1.6.

papisito

StevieJ wrote: »

What about exchange rate considerations, depending on when you invested, say 2007 you may have seen a 25% out performance purely on the Stg/Usd rate dropping from 2 to 1.6.

Great point StevieJ. I will try to look that up.

Loughton_Monkey

Now we live in a 'globalised' economy, then I would say that all equity funds are correlated. Almost on a daily basis, but certainly on a longer basis. In other words, look at the 'shape' of the graph and you will find it generally the same whatever country's main indices you are using. The only difference is the scale of variation and the long term net growth.

So territories are important to optimise your equity growth, but if you want diversification, consider commodities, property, and fixed interest.

StevieJ

Loughton_Monkey wrote: »

So territories are important to optimise your equity growth, but if you want diversification, consider commodities, property, and fixed interest.

I suppose commodities would be positively correlated to producer countries and negatively correlated to consuming. Having said that, Brazil has had a torrid time but commodities have prospered.

Linton

All the general funds in the major markets will be highly correlated as these funds will be dominated by large global companieswhich will be subject to much the same economic environment.

I believe you will reduce the correlation by going for more niche sectors. In addition to Loughton M's suggestions, I would add technology, small companies, Recovery/Special situations. The latter two are correlated broadly with the major markets but tend to do much better in the good times.