The New Commonsense Guide to Your 401(k): Rebuilding Your Portfolio From The Bottom up

Chapter 45. Correlation

ALTHOUGH YOU NEED not be a professional investor to make a good job of investing your 401(k) funds, I think it's worthwhile to look at some of the tools pros use to wring the emotion out of the investment equation. Emotions are a wonderful and necessary thing for a fulfilling life, but they have no part in investing. Most mistakes individual investors make come from emotions like fear and greed or, in the case of 2008 and 2009, sheer terror. Investing is a bit of science and a bit of art, but it should never be emotional. Selling on fear is another way to almost guarantee a loss.

One important investing tool is to examine correlation between different asset classes in your portfolio. Correlation measures the way two securities, mutual funds, or electronically traded funds perform relative to one another. Ideally, you want asset classes that perform well in different market environments. Accomplishing this is increasingly difficult because world markets more often move in tandem today. During the market plunge of 2008, it was impossible to avoid the disaster. Every asset class was hit at the same time, some more than others, true, but nobody escaped. Even careful experts like Ross Levin and his colleagues at Accredited Investors in Minneapolis got caught. Consider that in 2000, when the market lost 50 percent, Levin's client portfolios lost about 11 percent. But during the 2008 to 2009 period when the market lost 50 percent, Levin's portfolios lost 35 percent—better, ...