Here is one of those demonstrations that you really can try at home, without endangering yourself or your cat.
In one hand, hold a golf ball, and in the other a tennis ball. Hold both balls out in front of you, about a foot apart and about four feet off the ground. Drop both balls at the exact same time. What happens?
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If the laws of gravity are still in force where you happen to be, both balls should hit the ground at exactly the same time. That’s not important to our discussion; what happens next is. What happens next is that on the first bounce, one of the balls rebounds higher than the other. (You’ll have to perform the experiment to see which one it is.) And after several more bounces, the two balls will be out of sync: one will be rising while the other is falling, and vice versa.
Those two observations are useful in the discussion of diversification that we’ve been having over the past few weeks, including the role of cash in a portfolio.
Most investors know, even if they don’t actually practice it, that they should have a complement of bonds in their portfolio to offset the volatility of the stock market. If the fixed income component tamps down the overall volatility of the portfolio, it’s more likely the investor will be more emotionally able to ride out the down periods of a stock market decline, which is a good thing, because buy-and-hold investing routinely beats market timing in terms of long-term returns.
The naïve belief is that it makes sense to add bonds to a stock portfolio because when the stock market is falling, bonds do well, and when the stock market is going up, bonds are weak. In techno-speak, the assumption is that bonds and stocks are negatively correlated. But they’re not.
In fact, the stock market and the bond market are actually positively correlated. In other words, they go up and down together more often than they go in opposite directions. Like the two balls on the rebound after the first bounce, they both move in the same direction. They just do so at different speeds, with different amplitudes.
The data that I have show the correlation between the TSX Composite Index and the Canadian bond market to be +0.3367. Any positive correlation number means the two markets move together in the same direction at the same time. If the correlation between the two was +1.0000, it would mean the two markets move in absolute lockstep with each other; if it was -1.0000, it would mean they move equally and opposite to each other, which would give you a perfect diversification effect.
So the fact that stocks and bonds are positively correlated belies the belief that the bond market and the stock market move in opposite directions more often than they move together. The reality is that bonds do provide somewhat of a diversification effect to a stock portfolio, but with a correlation of +0.3367, they don’t do as good a job of it as more naïve investors think they do. If some other asset class had a lower correlation (than +0.3367) with the stock market (or ideally a negative one), that other asset class would do a better job of reducing overall portfolio risk.
That’s where cash comes in. The stock market and the money market have a historic correlation of just +0.0893. You could say that cash is four times as effective at diversifying stock market risk as bonds are.
Incidentally, the correlation between the bond market and the money market is about +0.5241. So cash and bonds don’t do much to diversify each other, but cash is far better at offsetting stock market risk than bonds are.
So cash doesn’t always pay that well in terms of nominal return, but it sure can play a strategic and tactical role in your portfolio. Cash is not there just to pay nuisance expenses like management fees and taxes. It has a legitimate portfolio role as well.
We’ll tackle the second observation — the balls out of sync — another day.
A big role for cash
Diversification: Bear-back investingInvestment risk: Nerve medicine
