The Key to Investment Success

Understanding Low Correlations

here's an ancient Chinese curse (or so we’re told) that inveighs, "May you live in interesting times!" In that sense, the past year has certainly been one of the more interesting times in which to be managing investments; the phrase "bear market" doesn’t adequately capture how it really felt.

For example, consider the stocks that were among the most widely held by investors at the beginning of the year (display right) — indeed, some of the best and largest companies in America. In first-half ’02, the money lost just in these firms alone approached a trillion dollars — and that was only this year’s losses; it doesn’t take into account what happened between the market’s peak in March 2000 and the end of 2001.

All of which reminds us that the future truly is unpredictable. Who’d have thought, a couple of years ago, that the booming stock market might suffer three down years in a row? (If that happens, it will be the first time in six decades.) And there are other key facts we try to emphasize — for instance:

That no one market always wins;
That while we try to keep our eyes on the long term, it's the short term we have to live through;
That the pain of losing money is far more intense than the pleasure of a comparable gain.

Our task has always been to help clients deal with these realities. After intensive research, the strategy we recommend is one that's actually guaranteed not to win in the short term; it will never do as well as the hot strategy of the moment. But it is also guaranteed to curb losses. It’s a simple strategy that, if executed correctly, can be astonishingly powerful: Combine a number of investments that are each sound in the long term, but tend to perform differently in the short term. This approach should allow you to increase your capital more confidently over time, and with less risk, than more aggressive strategies that may work better in the short term.

Stocks: A Panacea from Afar but Turbulent Up Close

It's hard to remember these truths when the markets are doing well. When you look at the U.S. stock market in the long-term, it looks like a no-brainer (display top). From a bird’s-eye view, the market almost always goes up! Even the worst of times — which are highlighted in the boxes on the chart — don’t look so bad from a long-range perspective. Yet they were brutal at the time. For example, by September '74, after 21 months of a bear market, investors had lost almost half the money they’d had in stocks.

But that was a generation ago. So when almost exactly the same thing happened again at the beginning of the 21st century, it came as a rude shock. If you were completely in tech stocks — if all your investments were in the Nasdaq index — your shock probably became panic.

Our goal at Bernstein is to take every step we can to prevent our clients from getting into such pre-dicaments, because the mathe-matics of money is that it’s much easier to lose than it is to recoup (display bottom). Say, for exam-ple, that you had invested in an index fund, down (46)% from the market’s peak on March 24, 2000, through what could turn out to be its trough, on July 23, 2002. It would take an 86% gain to get you back to break-even. And if that index fund happened to be in the Nasdaq index, down (75)%, you'd need a gain of more than 300% — in other words, your portfolio would have to quadruple — just to get you back to where you started.

So it's been our mission over the years to offer our clients a broad menu of investments aside from U.S. stocks (which generally form the core of their portfolios). In addition to domestic value and growth stocks, we offer bonds — taxable and tax-exempt — foreign stocks from both the major and emerging markets, a real-estate investment trust fund and hedge funds. These building blocks weren’t chosen randomly. Each asset class exhibits certain characteristics helpful in making a balanced portfolio work, as we'll see below.

Well-Balanced Accounts Don’t Lose Often

Having managed balanced accounts for almost 30 years, we have lots of data to draw on to demonstrate how this strategy works. We used to define "balanced" as simply holding both stocks and bonds, although with our broader product offerings today our balanced accounts now contain stocks, bonds and/or any of the other types of assets mentioned above.

We're not claiming that a balanced account will never lose money. But over 12-month periods, losses have happened rarely. From 1974 through second-quarter '02, our balanced accounts made money in all but 15 of the 111 overlapping 12-month periods (display above, left). And most of the losses were quite small. Over five-year periods (display above, center), they experienced only gains; in fact, the worst five-year result was an annualized gain of 4.8%, after all costs. Over 10-year periods (display above, right), the results were actually somewhat predictable, and the worst was a gain of 9% a year!*

Less Severe Losses = More Growth

Putting it all together—even with the bonds they contained — these balanced accounts, after fees, came within 1½ percentage points of the S&P 500's annualized return since 1974 (see bottom display on page 3).* The reason was that they were down less than half as much as the S&P in bear markets, posting an average loss of (7.4)% versus (19.9)%. Our balanced accounts didn’t have to expend all that energy getting back to break-even!

But what makes a balanced account “balanced”? Not just adding together any bunch of investments. If they happen to correlate closely with one another — when one goes up the other also goes up, when one goes down the other goes down, and in a similar amount — you don't really have a balanced account. It would be a lot like splitting your money among three stocks, but they’re Ford, GM and Chrysler; they’re apt to behave a lot alike, and you don’t get a diversification benefit. On the other hand, when various investments display low correlation with one another, you do get the diversification benefit.

Stocks and Bonds: The Classic Mix

Ideally, you’d like to find good investments that have negative correlation, meaning that while they all go up in the long run, when one goes down in the short term, the other goes up. But because that's so unlikely, we settle for low correlation — and the lower the better. There is, however, one combination that comes close to meeting our ideal standard: stocks and bonds. Since we've been keeping data, every time the stock market has taken a bad fall, bonds have made money (display below) — sometimes lots of money, as during this latest bear market. That’s why stocks and bonds are the basis for all balanced accounts.

The virtues of bonds aren’t always clear; when stocks are going gangbusters, bonds seem mediocre and boring. That was the scenario during the bubble years. But what a stabilizing force those bonds have been ever since the stock market turned hostile!

No One Asset Always Works

But the true "power of balance" goes beyond putting stocks and bonds together — because there's literally a whole world of other capital-markets assets to choose from. So we examined how a representative sample of those assets behaved during two traditionally difficult environments. The display above shows what we found when interest rates rose and when the economy was in recession, using index data for various periods over the past quarter-century.

In the first rising-rate episode shown above, the best performance was turned in by real estate, and the worst by bonds—though even the bonds made money. In the second period, stocks of the major foreign markets did best, and the emerging markets were in last place, with a (7.3)% loss. But if you then decided to avoid emerging markets during rising-rate periods, you missed out on a huge payoff at the end of the century. Meanwhile, value stocks, which did better than average the first time out, turned in a 2.6% loss each of the other two periods, coming in last place in the most recent period.

As for the recessions, bonds did best in the first time period — as you might have expected. But the second time, growth stocks were the winners — a real surprise. And in the most recent recession, real estate was the top performer. So it goes to show that you can never really predict the markets.

The Case Against Market-Timing

Still, lots of people can’t resist the temptation of trying to time the market. When things look lousy for the stock market, it’s simply intuitive to move money out of stocks and onto the sidelines. This almost never works, though, because stock returns often come in quick bursts, and it’s just too hard to predict when they will occur. In the left display on the facing page, we dissect the return of the S&P 500 and its predecessor indexes over the past three-quarters of a century: from 1926 through midyear 2002—about as broad a swath of history as you can get in the capital markets.

When we reviewed this very long-term record—comprising 918 months — we found that the average return on stocks was 1% a month. But nearly all the price gains came in just 60 of those months, only 7% of the time. During those months, the average gain was 12%; the rest of the time, the monthly average was just two-tenths of 1%!

And then we looked at the flip side: What if you had the extraordinarily good fortune to have missed the 60 worst months? Well, then you would have avoided an average monthly loss of 11%, and wound up making not 1% a month for the 858 months you’d have been in the market, but 1.8% — almost twice as much. And that doesn’t count the fact that you’d surely have put your money somewhere during those months — probably in Treasury bills — and so have come out even further ahead for the full period.

The problem is, how would you know when the best months were coming? And the worst? We wouldn’t have. Would you have guessed, for example, that you’d earn 17% in one month, October 1974 — after losing 12% in September, 9% in August and 7% in July? That the loss of 14% in August 1998 would be followed two months later with a gain of 8%? Or that a 7% loss in January 1990 would turn into a 10% gain by May? Clearly, being out of the market for even a few months could have had tremendous consequences, leaving you with far less money than if you had sat out the bad times. Mistakes like that (plus the cost of moving money around) are why the average investor in U.S.-stock mutual funds made only 5.3% a year between 1984 and 2000 while the average U.S.-stock mutual fund compounded at more than 13% a year. Transaction costs, selling low and buying high all ate into returns.

Seeking Low Correlations with U.S. Stocks

Instead of trying to guess, we look for sound investment opportunities with low correlations to U.S. stocks (display right), and combine them in the proportions most appropriate to each client’s needs and constraints. For example, the corre-lations between emerging-markets stocks or real-estate investment trusts and U.S. stocks is quite low. And there’s effectively no correlation between the returns on cash and the returns on U.S. stocks. You can see that the dollar, too, moves without relation to the U.S. stock market, which adds to the diversification effect of investing abroad.

Bonds, too, move fairly independently of stocks, as do classic hedge funds, which invest short as well as long (and often in many global markets). Value stocks also move somewhat differently from the U.S. market, whereas growth stocks — often the largest-capitalization companies — are a fairly good proxy for the market as a whole.

Rebalancing Also Critical

But even constructing a well-balanced portfolio doesn’t take you quite far enough. You also have to make sure that your portfolio stays well balanced. In other words, as one asset naturally outperforms another in the short term, the proportions you initially decided on for your portfolio will be thrown off. If you opened a U.S. stock account in 1998, for instance, with $1 million divided evenly between growth and value stocks, after two years of stupendous outperformance by growth stocks your account would have comprised almost 70% in growth and only a little over 30% in value.

If you didn’t rebalance — which would have meant taking some of those growth-stock profits and investing the proceeds in value stocks to bring your proportions back to 50/50—you’d have been overexposed to growth stocks over the next 2½ years, when growth had one of its worst spells on record and value recovered. As a result, by the end of July ’02 you’d have gained only $9,000 on your million over the entire 4½ years — a lot less than the $67,000 you’d have pocketed if you had rebalanced.**

Rebalancing Is Most Crucial in Volatile Markets

Rebalancing makes the greatest difference when there’s lots of volatility in the market. In such times, accounts get out of balance more often and more dramatically, providing bigger opportunities to sell high and buy low. But while it may not always add to returns as in this example, rebalancing always works to keep your risk level steady. Not that it comes easy; think of those terrible months when the market was down (10) or (12)%. That's when you’d have been inclined to flee, but it would have been far wiser to take some funds from an asset that was going strong and use them to buy lower-priced stocks. And those stupendous gain months were the times to keep your portfolio in balance by drawing some of the gains from your stocks and putting them to work elsewhere. It's a big part of succeeding at "buying low and selling high."

Why doesn’t every-one do this? Because it’s hard. It’s very difficult emotionally to systematically trim your winners and reinvest the money in your losers! But if both categories include fundamentally sound investments, this is a key contributor to maximizing long-term return.

So our recipe is to look for low-correlating assets, to balance clients’ portfolios among those assets according to each client’s risk/return profile, and to rebalance when they stray too far from the desired proportions. But now for the acid test: How have these balanced accounts performed in the latest bear market?

The display above gives the year-by-year record starting with 2000, the year the bear market hit. Not all of 2000 was down; in fact, value stocks had stellar perfor-mance during much of this period. Still, the market fell (9.1)% in 2000, while our balanced accounts were up 5.7% on average after all costs. In 2001 the market was down (11.9)%, and our balanced portfolios were up 3.1%. This year our balanced accounts were down through July—but by (7.7)%, compared with a drop of (19.9)% for the market. Putting it all together, from the beginning of 2000 through the end of July 2002, while the S&P 500 fell a devastating (35.9)%, our balanced accounts eked out a gain of 0.7% after all costs.

And so it may be true that nothing always wins; that it’s the short term we have to live through; and that the pain of loss is more intense than the pleasure of gain. But we strive to help our clients see the other side: that nothing always loses; that it’s the long term that counts most; and that the pleasure of gain ulti-mately wins the day. To do that, we keep expanding the list of low-cor-relating markets and investments we can offer, and manage each piece drawing on our research resources and long experience.

Has Globalization Made Foreign Stocks Old Hat?

The world seems to be getting smaller every day—particularly when it comes to doing business. Instantaneous communication, rapid technological progress and expanding cross-border commerce have led to a growing notion of a “one-world” economy. What’s more, the U.S. and international stock markets seem to have been moving more in tandem of late than usual. With more synchronous behavior of stocks worldwide, does it still make sense to invest abroad?

Based on our research, the answer is a resounding yes. The reasons? First, modestly higher correlations between the U.S. and foreign markets don’t mean that there’s no benefit. No matter how global industry dynamics become, companies still respond in significant measure to local forces driving local markets. Second, and more important, opportunity knocks. Nearly half of the world’s stock capitalization now lies abroad, and we recommend including the very best investment opportunities from that vast storehouse of potential growth.

We’d emphasize a few key research findings:

Several forces are behind the step-up in U.S. and foreign correlations—First and foremost is the rising tide of globalization. And other, newer, forces are also at play, making stock markets worldwide behave more like one another. Probably the most important among them are the rise in foreign ownership of stocks in most markets and the growing global convergence of interest rates—the latter courtesy of the European union and successful inflation-fighting by the world’s major central banks. Furthermore, tumultuous periods tend to drive correlations higher, as we saw with the Internet bubble—but those effects historically have been short-lived.

Currency provides additional diversification benefits— Not only do the world’s stock markets not march in lockstep, but currency movements are weakly correlated with most other assets—even with their own local stock markets. So the currency exposure that comes bundled with owning international stocks—which we carefully manage, since cur-rency adds risk as well as potential return— represents another layer of diversification.

It’s the companies that count, and many industry leaders are based overseas—The bigger story is the long roster of major companies that reside outside the U.S. It may surprise you to learn how much of world banking is headquartered outside the U.S., and how much auto-making, household-durables manu-facturing (display) and a host of other industries. Think Electrolux, Société Générale, Volkswagen and Yamaha, to name just a few—all of which we own in our International Value portfolios.*** Our job, as we see it, is to uncover the best opportunities for our clients, wherever the companies are headquartered. Country diversification is still an important consideration for us—but not as important as selecting the stocks our research suggests hold the most return potential.

Notes

^*See Notes on Performance Statistics and Simulation on pages 24–25.

^**Based on Bernstein’s rebalancing rules. In broad terms, those rules are as follows: Assuming a target proportion of 50/50 value/growth, when-ever a portfolio’s proportions drift by five percentage points either way—when, say, growth stocks have outperformed value stocks enough to skew the portfolio to 55/45 or more in growth’s favor—we rebalance by directing all dividends, interest payments and/or cash additions into the value half of the portfolio, or by selling some growth stocks to replenish the value stocks, until the proportions are back toward the desired 50/50 target. The tactic of first directing dividends and other cash received into the part of the account that’s performed least well, before sell-ing off any shares, keeps trading to a minimum. Note that for the illustration above we’re ignoring transaction costs and taxes, which would reduce the rebalancing advantage slightly—although those effects are factored into our actual rebalancing decisions.

^*** As of July 31, 2002, Electrolux represented 2.4% of our Tax-Managed International Value and International Value II portfolios, on average; Société Générale, 2.0%; Volkswagen, 1.7%; and Yamaha, 1.2%.