The following is an excerpt from

Big Picture Retirement Planning

Les Goldstein, M.B.A.

Personal Financial Strategies, Inc. PARK RIDGE, ILLINOIS

Copyright © 2018 by Les Goldstein.

The following content is for non-commercial educational use only. All rights reserved. No part of this publication may be reproduced, distributed or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other non-commercial uses permitted by copyright law. For permission requests, write to the publisher at the address below.
Les Goldstein/Personal Financial Strategies, Inc.
626 Busse Highway
Park Ridge, IL 60068
Book layout ©2013
Big Picture Retirement Planning/ Les Goldstein. —1st ed.
ISBN 978-0-0000000-0-0


Diversification vs. Non-correlation


During both the accumulation phase and the income phase of life, it is our belief that, depending upon your specific objectives and risk tolerance, you should continue to own growth-oriented investments. Why do you need to continue taking on this risk? Because inflation and the continuous need to spend more money to maintain the same lifestyle forces us to invest in assets that at least have a probability of increasing in value over time.

We believe that “growth-oriented” means stocks, growth ETFs, stock mutual funds, and real estate. Setting aside a discussion on real estate for now, let’s focus on stocks, stock mutual funds, and growth ETFs.

What we have learned over the years is that pretty much all growth mutual funds (invested in stocks, for the most part) and income mutual funds (invested in bonds, for the most part) tend to track their respective indices. That is, large-cap growth mutual funds typically perform in a fashion similar to the S&P 500, and long-term US government bond funds tend to track the performance of individual long-term US government bonds. This is due to a phenomenon known as correlation. Correlation, to me, means “sameness.”

It is our position that, in order to increase your chances for retirement investing success, non-correlation and proper asset class allocation can be more valuable than simply diversifying into different stocks, bonds, and mutual funds. We spend a great deal of time conducting correlation analysis on clients’ comprehensive investment portfolios. So, now let’s review what correlation analysis is all about.
Correlation analysis measures sameness and overlap. Morningstar’s definition of correlation is as follows: “correlation demonstrates the relatedness of return and patterns among in-vestments. It is based upon the correlation coefficient, a number between -1.0 and 1.0. A perfect linear relationship between two investments has a correlation of 1.0. A perfect negative linear relationship between two investments has a correlation of -1.0. A cor-relation coefficient of 0.0 indicates no linear relationship between the investments.”

In plain English, lowering correlation towards 0 lowers the probability that your portfolio mirrors the performance of the S&P 500. Remember, lowering correlation does not guarantee you retirement success. But, at least one of the many risks that your money will encounter over the years may be reduced by lowering the stock market risk.

Correlation analysis can be valuable in assessing the potential risk reduction that results when you combine one or more investments. To put this in more understandable terms, what happens when assets (in our discussion, stocks, bonds, and mutual funds) are impacted by a specific outside factor? This conversation is important because lowering the correlation of your investment portfolio is designed to result in decreased principal risk. Again, lower correlation does not guarantee smaller losses when the
stock market declines. But any advantage you can create for yourself may be beneficial over the long run.

Source: Advisory World SCANalytics Correlation Tool

This is an example of a highly correlated stock and bond mutual fund portfolio, being shared for illustrative purposes only. As always, it is an example, and your actual results will vary. The letters (for example, “SPY”) are ticker symbols that represent individual mutual funds. For the sake of simplicity, an equal amount was invested in each of the preceding securities. This is being provided for illustration purposes only.


Source: Advisory World SCANalytics Correlation Tool

This is a second example of a portfolio with much lower correlations. As I have already shared many times, this is for illustration purposes only, and your actual results will vary.

Different than the portfolio reviewed previously, this portfolio includes individual stocks in various industries, a municipal bond fund, even a US government securities fund. Again, an equal amount was invested in each of the preceding securities. The benefit of adding non-correlated or low-correlated investments is that losses can be reduced by lowering your concentration in highly correlated assets. Again, this is provided for illustration purposes only. The point here is that if you can lose less during bad times, you do not have to earn as much to get even and then ahead. If you lose 20 percent in one year, you have to earn 25 percent in the next year to get even!

PFS Pearl of Wisdom: You may feel that you are properly diversified because you own stocks and bonds and mutual funds with different names and even different operating objectives. Examine your accounts more closely to ensure their correlation for sameness. Random or even planned diversification may not be sufficient to lower the risks hidden inside your investment portfolio.

Here is an example to share the impact of losses when you are just entering into retirement. Let’s assume that you were able to accumulate $1 million in savings and investments for your retirement. And, for illustrative purposes only, let’s assume that you diversified your retirement savings and investments as follows:

  • $300,000 or 30% into SHY, an ETF that invests in 1 to 3 year US govt. Treasury securities
  • $300,000 or 30% into SPY, an S&P 500 ETF
  • $200,000 or 20% into FEZ, an international ETF that invests in large European companies
  • $100,000 or 10% into IJH, a US midcap cap ETF
  • $100,000 or 10% into VSMAX a US small cap mutual fund

This seems like a reasonable diversification, doesn’t it? High-quality bonds. Large-company US stocks. Large-company international stocks. Medium-sized US company stocks. Small-company US stocks.
Now, let’s assume that you need $50,000 per year from your investments, in order to meet your desired retirement standard of living. Sounds reasonable, right? Well diversified, right? And you happily retired, right at the end of 2007.

Unfortunately, 2008 turned out to be a very bad year to retire for investors in stocks and bonds. Here is what happened to the prior-listed investments:

  • SHY was fine and ended 2008 basically even.
  • SPY lost 38% and you lost $114,000 in 2008.
  • FEZ lost 46% and you lost $92,000 in 2008.
  • IJH lost 37% and you lost $37,000 in 2008.
  • VSMAX lost 36% and you lost $36,000 in 2008.
  • Total losses: $279,000, leaving you with $721,000
  • Minus your $50,000 withdrawal to live on, leaving you with $671,000.

Ouch! Of course, this is an example only to illustrate a point, and your results could have varied. And, this illustrates a very bad time in the US and the global economy. Commissions, fees, and potential taxes were not included in this illustration.

So, what was the point of all that diversification? It seems that it was completely without value. The combination of being in the distribution phase of your financial lives, combining taking money out of accounts at the same time you are experiencing losses, may result in your running out of money way before you “run out of life.”

Source: Advisory World SCANalytics Analysis Tool

This chart is for illustrative purposes only. Prior performance does not guarantee future results.
With a correlation of 92 percent, this hypothetical diversified portfolio has a 92 percent “sameness” (correlation) to the S&P 500. In theory, it may have been reasonable to have invested in only one S&P 500 Index ETF to achieve basically the same result. And you would have lowered your need to track multiple investments, as well as reducing the amount of trees that were wasted to provide you with monthly statements, quarterly statements, and prospectuses that most investors do not read anyways.
When new clients come in, more often than not they own 10, 15, 20, or more mutual funds. As a matter of fact, the record number of mutual funds we ever saw in one client’s portfolio was 63! Diversification at its utmost. Diversification is supposed to lower risk. Haven’t we all been told to not keep all our eggs in one basket?

To further illustrate this point about sameness or correlation, the following Chart 1 below, represents the performance of a million-dollar portfolio invested equally into each of the 10 largest (by money under management) large-company US mutual funds beginning in 2008 and ending on December 31, 2016, compared to the performance of the S&P 500 for the same period of time.

Chart 2 shows the 92% correlation of these 10 mutual funds and the S&P 500. The higher the correlation, the greater the sameness.

Chart 3 represents the same study for the Russell 2000 (a small-cap stock market index consisting of the smallest 2,000 stocks in the Russell 3000 Index (please remember that you cannot invest directly in an index), comparing the Russell 2000 to the 10 small-cap mutual funds with the largest dollars under management.

Looking at Chart 4, we again see a very high sameness/correlation between a diversified portfolio of small-cap stocks and the small-cap index, this time 95%. And again, massive losses just now fully recovered by our positive stock market gains since 2009 through the end of 2017.
As always, prior performance is not indicative of future results. I am just sharing these examples to prove a point. However, I have always believed that history does repeat itself!

Chart 1: Historical Performance of the 10 Largest Big Company Mutual Funds in USA
Source: Advisory World SCANalytics Analysis Tool. For illustrative purposes only. Prior performance does not guarantee future results.


Chart 2: Correlation of the 10 Largest Big Company Mutual Funds in the USA
Source: Advisory World SCANalytics Analysis Tool. For illustrative purposes only. Prior performance does not guarantee future results.


Chart 3 Historical Performance of the 10 Largest Small Company Mutual Funds in the USA
Source: Advisory World SCANalytics Analysis Tool. For illustrative purposes only. Prior performance does not guarantee future results.


Chart 4: Correlation of the 10 Largest Small Company Mutual Funds in the USA
Source: Advisory World SCANalytics Analysis Tool. For illustrative purposes only. Prior performance does not guarantee future results.

Looking at the preceding charts, you can see that all the correlations are in the high 90s. All these mutual funds and ETFs with their different-sounding and exotic names have historically generated similar outcomes as far as long-term rates of return and direction of price movement. When I first figured this out early in my career, I was very disappointed. How could I, as a stock broker, truly help my clients? One possible answer, in addition to our philosophy of comprehensive financial planning with a focus on retirement income planning, is to add non-correlated and low-correlation assets to our clients’ portfolios.

For example, listed equity REITs offer the potential for the reduction of correlation, potentially reducing your portfolio risk.


As this chart suggests, correlations between listed equity REITs and various stock market sectors over the last 25 years range from a low of 25% correlation to telecom stocks, to a high of 63% correlation with stocks where the companies are in the business of materials. Lower correlations may suggest that whatever factors impact the performance of the non-REIT sectors of the stock market, these factors will not necessarily spill over to affect the REIT market. In our opinion, this is a good thing. Not having everything so closely tied together can potentially lower the overall risk of your portfolio.

Here is a second chart that is worth reviewing. Diving a bit deeper, this chart looks at REITs and all major asset classes. Again, please note the relatively low correlations between REITs, large, medium, and small company US stocks and US bonds.

Source: Nareit Analysis using Matlab with Kevin Shepard’s DCC-GARCH rou-tine, 1/12/2016.

It is also important to understand that these two charts refer to listed (traded) REITs. For our clients, we prefer non-listed (non-traded) REITs. It is our position that investing in real estate is a long-term proposition. If you feel the same way, why should the value of your long-term real estate holdings be impacted by the daily ups and downs of the stock market? For this reason and more, our clients’ long-term real estate assets, at least through us, are in non-traded REITs.

When you are deciding between traded and non-traded REITs, there are other factors that come into play. Traded REITs are liquid. That is, your shares in traded REITs and traded REIT mutual funds can be sold any day. It may be less costly to invest in traded REITs, where all you may have to pay is a ticket charge (commission) to buy or sell. With traded REITs, you are absolutely going to be impacted by the daily machinations of the stock market. As an example, looking back at the period from 6/1/2007 through 12/31/2008 (a very bleak time in the US and world economies), the S&P 500 as measured by the ETF SPY lost nearly 42%. Traded REITs, represented by the Vanguard REIT ETF VNQ, lost over 54%!

Non-traded REIT are illiquid by design. These are long-term investments, often 7 to 10 years in life, and it can be difficult to sell a non-traded REIT before the issuer offers a liquidity event, typically a listing on a stock market exchange or the sale of the entire REIT portfolio to a third party. Non-traded REITs may also have higher fees than traded REITs. Non-traded REITs are offered by prospectus only; be sure to review the prospectus for a complete list of the costs, risks, features, and benefits of each non-traded REIT that you are considering as a possible investment for your retirement income portfolio.

As the preceding chart shows, correlation with the broader market decreases as investment time horizons lengthen. The longer the time frame, the lower the degree of “sameness.” Also, please note that this chart is for publicly traded REITS. Non-traded REITs, our preferred ownership type, should, by their very nature of illiquidity, have even lower correlation than their traded REIT brethren. The non-traded REITs’ correlations to the stock market should pick up only after a liquidity event, such as a listing on a major stock exchange. We believe that the non-traded nature of our preferred REITs gives an added layer of insulation from the vagaries of the stock market to our clients.

Now, just adding non-correlated and negative-correlated assets does not mean that you will not lose money. The addition of non-correlated assets is meant to lower overall portfolio risk and to have an allocation to assets that may increase in value when other assets are experiencing losses. Some investments even have a negative correlation to the S&P 500 or other major stock market indices. Examples include investments such as ETFs and mutual funds that are structured to go up when the stock market goes down. This is an example of a “hedge” for yourself. An investment like this certainly has risk, and should not be used carelessly. Just another tool that’s worth knowing about.


Important Disclosures for This Chapter

It is important to understand that everyone’s situation is unique, and not all strategies and methods mentioned in this book may be appropriate or suitable for every individual. We suggest that you consult fully with your financial, tax, and legal advisors on pursuing a strategy that is uniquely tailored to your particular needs.

Diversification and non-correlation seek to reduce the volatility of a portfolio by investing in a variety of asset classes. Neither non-correlated asset allocation nor diversification guarantee against market loss or greater or more consistent returns.

REITs are sold by prospectus only. Investors should carefully consider objectives, risks, charges, and expenses before investing. The contract prospectus and the underlying fund prospectus contain this and other important information. Investors should read the prospectus carefully before investing. For a copy of the prospectus, contact your financial advisor. Non-traded REITs are long-term, illiquid investments. Do not invest in a non-traded REIT unless you are able to hold the investment for its entire term. Review the prospectus for a comprehensive outline of the features, benefits, risks, and rewards of each REIT investment. Substantial fees are paid to the offeror of each REIT investment, including but not limited to fees for the organization, operation, and liquidation of each REIT.

Mutual funds and ETFs are sold by prospectus only. Investors should carefully consider objectives, risks, charges, and expenses before investing. The contract prospectus and the underlying fund prospectus contain this and other important information. Investors should read the prospectus carefully before investing. For a copy of the prospectus, contact your financial advisor.

Investing in common stocks of any publicly traded company involves risk. Investors should review all available information, including company financials, SEC filings, and independent research reports prior to investing. Not guaranteed. You can lose money.

All investments involve the risk of potential investment losses, and no strategy can assure a profit. Past performance does not guarantee future results.