Why a crisis will show how diversified you really are

If you own an ETF that tracks Singapore's STI, some bonds, and an Asia Pacific unit trust, you might think your portfolio is diversified. But it probably isn't.

Investing in assets with low correlations is a cornerstone of portfolio planning. When assets have a negative correlation, they tend to move in opposite directions. And, conversely, when their correlation approaches 1, it means they tend to move in the same direction at the same time.

To build a well-diversified portfolio, you need a mix of assets with low correlations. That way, when one investment drops in value, the other investments should hold their value, or move up. This will help offset any (temporary) losses.

This generally works well over the long term. Looking at historical correlations shows that over the past 28 years, the S&P 500 and bonds have had a correlation of just 0.29. The MSCI EAFE Index (representing developed markets) and the MSCI Emerging Markets Index have a historical correlation of 0.7, as shown below.

This changes when disaster strikes
But historical correlations go out the window when there's a financial crisis. Almost regardless of the asset or market, correlations spike. A good example is the global economic crisis of 2008-2009 (correlations for the table below were calculated from November 2007 to February 2009). For example, the correlation between bonds and the S&P 500 jumped to 0.53. The correlation between emerging markets and developed markets rose to a near-perfect 0.94 (a correlation of 1 means two assets move in perfect unison).

So, during a financial crisis, most assets do the same thing – that is, they go down. That's because when there's a crisis fear and panic rule and investors sell everything they can – whether it's stable bonds or volatile emerging markets.

The one asset every portfolio should hold
But one asset does better than others when there's a crisis – gold. Gold is great portfolio insurance and has a low correlation with all major stock markets. In 2008, gold prices rose 6% – while the STI dropped 49%, the S&P 500 fell 38%, and the financial system nearly collapsed.

In other words, a well-diversified portfolio should include gold. To add it to your portfolio, try the SPDR Gold Trust ETF. It owns physical gold bullion and allows you to track gold prices. On the Singapore Exchange, it's code O87.

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