The drama in Europe is putting the best-laid investing plans to the test. Each day, it seems, stocks are either soaring (“risk on”) or plunging (“risk off”)—yet for the year the Dow Jones Industrial Average has barely budged.
The main culprit: “correlation,” or the extent to which assets move in unison, which reduces the benefits of diversification and limits investors’ ability to control their portfolios. According to Birinyi Associates, the correlation between the stocks in the Standard & Poor’s 500 and the index itself rose as high as 0.86 in October—nearly a perfect 1.0—from as low as 0.4 in February.
But don’t despair. By changing the way you spread out your stock holdings, you can reduce risk and boost returns—even in a highly correlated market like today’s.
The trick? A concept known as “factor investing,” which originated in academia two decades ago and now is finding favor among institutional investors and high-end financial advisers.
Factor investing replaces traditional asset allocation—such as a portfolio with 30% in U.S. stocks, 20% in developed international markets, 10% in emerging markets and 40% in bonds—by focusing on specific attributes that researchers say drive returns. These “risk factors” include the familiar—like small versus large-size companies or growth versus value stocks—as well as more esoteric measures such as volatility, momentum, dividend yield, economic sensitivity and the health of a company’s balance sheet.
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