Do small caps offer diversification?

By: ispeculatornew
Date posted: 08.28.2009 (5:00 am) | Write a Comment  (0 Comments)

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It is often said that a portfolio will offer a better return, especially compared with its risk when diverisification is used. Of course, there are many many different ways to view diversification but generally, investors diversify their portfolio through asset classes and among them. For equity, generally the biggest portion of a portfolio, that diversification can be made through various ways as well but one of the more used ways is to buy both small caps and large caps.

Generally, companies are rated according to their market capitalisation as bigger companies will of course be worh more. With that generally comes smoother results. You would certainly expect a major company like Dow Chemicals to perform better in a downturn than a small chemical company right? But surprisingly, as do many other assets, they all seem to move together in stress periods and the 2 graphs from the previous year do tell a lot.

The first one is the correlation between the S&P500 and the Russell 2000. As you can see, it seems like the return of the 500  biggest companies is almost exactly the same as the return offered by the Russell 2000 which tracks 2000 generally smaller companies. Currently, the correlation is at .9457

graph1

Even more surprising is the next graph. I figured that the comparison might be even more interesting using the Dow Jones Industrial average, an index that includes only 30 companies. The Dow Jones generally includes 30 of the most important companies in the US. Again, you can see that the Russell 2000 is almost perfectly correlated to the Dow Jones in the past few months. Quite impressive isn’t it? Currently, the correlation is at .9902

graph2

Is this relationship going to remain for a long time? Probably not. But it’s always interesting to see that in periods like the one we have just experienced, there really are very few assets or places to hide in.

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