Sunday, January 29, 2012

Correlation between asset classes

We have recently taken a look at allocation of asset classes. As a Calgary based investor, I have always been concerned about how similar or dissimilar the appreciation has been for different asset classes. To do so, I opened my spreadsheet that compares the Dow Jones with Calgary Real Estate prices (for a Single Family Dwelling). I have updated it for 2011 and… I have added a 3rd asset class: Gold.

The results were striking. Between 1973 (the start of my data base) and today (year end of 2011), $1 invested in Calgary Real Estate has appreciated to $17.46 while the Dow Jones appreciated to $14.36 and Gold to $16.92. Isn’t that something! All three classes show over time a very similar amount of appreciation (not counting net rental income and dividends). But the path that each class followed was quite distinct (see the graph below).
 Figure 1 - Appreciation of $1 invested in Gold, Dow Jones and Calgary Real Estate
A numerical expression of how distinct their paths were is called correlation. The poorer (lower) the correlation, the better for diversification. Gold is poorly correlated to the Dow (0.50) and it is a lot better correlated , but far from perfect, to Calgary real estate (0.84). The Dow and Calgary Real Estate are also showing a poorer correlation (0.82) than gold and real estate.  

The graph above shows that while the Dow was up big time in the 1990s, real estate was subdued; yet from 2000 until 2007 the pattern reversed showing rapid real estate appreciation. Gold was even more subdued in the 1990s  than the Dow and it performed also poorer than Calgary Real Estate. Yet since 2000, Gold has taken off like a rocket.

We have discussed risk before, but not in terms of standard deviation. Let’s see how the asset classes (Gold, Dow Jones, Calgary Single Family Dwelling) compared on that basis (table below).

Figure 2 Returns and Risk of Asset Classes
Not counting dividends and net rental income, there seems to be a relation between risk and reward. Since 1973, Gold has had the highest average annual return (10.2%) and Calgary Real Estate has had the lowest (8.5%). But real estate also experienced the lowest volatility (S.D. =9.7%) while Gold the highest (23.2%). During gold market downturns losses are typically as high as -36% (calculated based on average return and 2xS.D.). Yet, somewhat contradictory, the worst annual return experienced in the real world was a modest -25%, i.e. only slightly worse than Calgary Real Estate in 1984. The Dow Jones lost most between 1973 and 2011 with 34% in 2008 alone. On the positive side, both in real terms as well as when calculated for a typical bull market (Maximum Expected Return), gold has the best upside. So, a bit of the ‘Risk versus Reward’ equation is probably at play here.

In terms of appreciation, gold has since 2001 appreciated much faster (17.1% annually) than its bench mark rate of return (10.2%). This begs the question: 'for how much longer?' Calgary Real Estate experienced explosive value growth from 1996-2007 (12% annually) and in particular during the 2006 and 2007 years (39% and 27%). After 2007 appreciation has flattened to around 1.3% per year and the asset class appears to revert back to its long term bench markrate. Still an average long term annual appreciation of 8.5% (which equals a compounding rate of 8%) is still astounding. However, after removing the effects of oil price shocks a more normal pace of appreciation (3%) is revealed similar to what Calgary experienced between 1983 and 1993.

Finally, the stock market experienced appreciation above its 8.6% benchmark rate between 1994 and 1999 (25% per annum), followed by a volatile but modest actual appreciation from then onward (2.6%). Thus, it appears, that the stock market has now underperformed for the longest time, while Gold is an ‘accident waiting to happen’ and Calgary Real Estate is in a ‘Steady Eddy’ mode.

When looking at these three asset classes combined, they appear to create excellent components for a diversified portfolio. We also have an idea, based on the principal of ‘reverting to the bench mark,’ as to which of the three classes appears most promising and which appears most risky.

 Another other asset class that we have not yet mentioned in this post,  but that also has overshot its long term benchmark by a wide margin is bonds, in particular North American government bonds. With inflation not far away, these bonds are also due for a period of significant negative adjustments.
Nobody can look into the future but maybe we can extrapolate some of the trends we see here to create a suitable asset mix for the foreseeable future while controlling our risks. Gold has always played a very subdued role in my portfolio and I am reluctant to add a lot to my portfolio at this stage of the market. Yet, once gold has reverted to the benchmark or to even lower prices, I will definitely add it to my portfolio mix.

1 comment:

  1. Very impressive overview of the 3 major asset classes most prominently discussed in the marketplace today. The impact of standard deviation is not normally discussed, but from a correlation standpoint, I also believe it to be a significant factor to consider. Being a rather conservative investor, I'm much happier securing assets that exhibit lower standard deviation over a long-term period to mitigate the roller coaster effect of market turmoil. Thanks for providing this excellent overview! Harold Hagen