Article #585) Here's why "Correlations" matter

Updated: Nov 3, 2020

VTS Community:

Correlation and why it's so important:

Studies show the average investor only makes about a 2-3% rate of return in the long run.  That number may surprise you, but I'll explain one of the major reasons why that number is so low in this article.  2-3% a year in the long run, and remember inflation eats away at that even further so the average investor really is left spinning their wheels. 

Most of their retirement fund will be coming from savings alone, investment activity is not helping them very much.

To add to the problem, the personal savings rate in the US and other western countries has been declining for years.  In the 60's, 70's, and 80's it was averaging 12%.  In the last 20 years though that personal savings rate is down to just 6% for the average American.  So what have we got?

Low investing returns plus a steadily declining savings rate.

That combination in a nutshell is why you may be seeing a lot more articles in the last several years talking about the impending retirement crisis.  It's real.  That's not what this article is about so I'll circle back to that at another time, but why the low rate of return?Why 3% a year on average in the long-run?  Hasn't the S&P 500 returned much more than that in the last decade?

S&P 500 annualized return for the last 10 years:

Yes it has.  Adjusting for inflation and including reinvested dividends along the way, the S&P 500 has returned about 7.7% a year for the last decade. 

However, it's been a 10 year long bull market so it's not really a meaningful comparison if you only include the best years.  At some point we're going to enter a full on recession.  Who knows if that's what we're in right now and how much worse it's going to get, but at some point this bull market will end for an extended period of time.

So if we add 10 more years to that and count the last 20 years, which then includes 2 bull markets and 2 bear markets, then the long term annual rate of return is down to just 2.3% a year.  That is much more in line with long term expectations when including good years and bad years.

S&P 500 annualized return for the past 20 years:

And remember, 85% of fund managers  (and by proxy most investors)  underperform their benchmarks.  The S&P 500 is one of the best performing benchmarks in the world. 

So what rate of return do you think the average investor gets in their overall portfolio when 85% of them can't even beat 2.3% a year in the long run?  Well, it's a very low number isn't it?  Studies show, it's around 2-3% at best.

Why is this happening?

It's not just one thing, there's several contributing factors, but one of the biggest reasons for the painfully low performance in the long run is correlation to the S&P 500.

The average recession cycle in the United States is roughly 6-7 years.  Since most investors are highly correlated to the stock market, that means every 6-7 years on average they see their investment portfolio tank, maybe down 30-40% or more.  In the last financial crisis the S&P 500 dropped -57%.  Now of course most people don't hold their entire portfolio in stocks, but for many it is their largest allocation.

A long-term rate of return has to include those bad periods as well right?  If we do, that very quickly destroys the gains that were made during the good periods.

Well, we're in year 10 of the longest bull market in history now.  We may have just ended it but it's only been a few weeks so we'll see how this plays out.  Regardless, when this party ends, whatever performance investors have gained in the last 10 years, we can expect the vast majority of them to give up a good chunk of it, and probably a little beyond that simply due to additional mistakes being made in the panic.

A long term rate of return includes both bull markets and bear markets.  Both good times, and crashes.  Since most investors are highly correlated to the stock market, they regularly see their portfolio rise and fall with the business cycle.  

They're happy, then it crashes.  They build it back up, then it falls again.  Over and over every 6-7 years on average, rinse repeat.

Solution:  Seek low correlation to the stock market:

One of the best ways investors can avoid this vicious cycle is to allocate towards strategies that demonstrate lower correlation to the stock market.

All 5 VTS strategies and correlation to each other and the S&P

Given that it's been a 10 year bull market, all 5 VTS strategies show a very low correlation to the S&P 500.

Reminder, the Vanguard VBINX which is one of the most popular balanced index funds out there has a 97% correlation to the S&P 500, and hedge funds are at around 90% correlation.  

The fact that the VTS Total Portfolio Solution is only 34% is something I'm very proud of.  And the strategies also have low correlation to each other, which is why they all compliment the overall portfolio so well and add true diversification.

Often times fund managers tell their clients they are "diversified" because their money is in several asset classes that sound different.  Stocks, bonds, real estate, hedge funds, commodities, emerging markets, utilities, REITs, etc.

They all sound pretty different so combining them all should be good diversification right?  Unfortunately no, the mathematical correlation of many of those assets is pretty high, especially in a market panic.  We saw that this past month where I showed that in the panic, inter-asset correlation rises substantially and most things start going down.

In a crisis, most investors realize very quickly how NON-diversified they really were.

VTS strategies all show very low mathematical correlations to each other and importantly, to the stock market, which is one of the big reasons I've managed to keep my maximum drawdown in the overall portfolio to mid single digits.  

Correlation to the S&P 500

Ignore this statistic at your own peril my friends.  It's highly overlooked, but 10 years into the longest bull market in history, it may be time to start paying attention to it.

Have a fantastic weekend, and check out this video on correlation to the S&P 500 when you have time.  What am I talking about, of course we have time, we're quarantined  :)

Stay safe everyone!

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