Most portfolios have enjoyed some recovery in recent weeks from the Fed fear factors that roiled the markets in May and June. But this spring’s market gyrations emphasize the importance of holding onto some basic truths about short-term versus long-term investing.
Active traders may try to make big short-term money by identifying mispriced assets and picking the right stocks and industry sectors. But for most investors, with longer-term horizons, using the power of diversification is what matters most for reducing the likelihood of portfolio losses and maximizing long-term returns. Knowledge about how different stock market sectors move in relation to the broader market over a multi-year time horizon can provide the roadmap to better investment results.
An analysis by the National Association of Real Estate Investment Trusts (NAREIT) yields some surprising findings. In the short-term, the returns of many industry sectors show only moderate correlation to the broader market, and thus seem to provide portfolio diversification. However, on a five-year basis, most stock market sectors are approximately 90 percent correlated with the S&P 500 Index. Consequently, spreading your investments across industry sectors provides relatively little meaningful diversification over the longer term.
There is one segment of the stock market, however, that provides dramatically lower – and steadily declining – correlations to the broader market over holding periods ranging from six months to five years: publicly traded REITs. Adding REITs to a portfolio offers potentially more promising opportunities for portfolio diversification within the stock market.
Over time, most sector movements match the stock market
If you look at very short-term time periods – a day, a month, six months – there are considerable differences in the movements of different stock market sectors. In technical terms, correlation with the broader market is relatively low.
But for most sectors, the longer the period, the closer the individual sectors tend to match the overall stock market trend. A NAREIT analysis used public market data to compute correlations for various industry sectors versus broad market benchmarks such as the Dow Jones Total Market Index and the S&P 500 Index from January 1990 through March 2012, and looked at investment horizons ranging from one-month (annualized) returns to 60-month (annualized) returns.
The charts below show how return correlations between several industry sectors and the Dow Jones Total Market Index increase as the investment horizon lengthens. Over a 60-month (five-year) time horizon, many sectors – including industrials, financials, technology, healthcare, consumer discretionary, and telecom – are correlated with the stock market as a whole by 89 percent or more. Energy and materials industry stocks are less correlated as they are linked more than other industry sectors to commodities cycles.