If an investment bank came out with a contract based on injuries to Yankees' pitchers, chances are that some advisors would take a close look. Just as likely, there would be approving comments to the effect that such an investment would not be correlated to other asset classes. After all, a shin-cracking comebacker would not have an effect on, nor be affected by, moves in the S&P 500.

During the last bear market, investors rediscovered asset allocation—that it pays to invest in asset classes that don't move in the same direction as stocks or conventional bonds. But correlation is a moving target. It changes for different asset classes under different market conditions—as was evidenced by this summer's volatile markets.

Offsets

Michele Gambera, chief economist at Morningstar's Ibbotson Associates subsidiary in Chicago, ran some numbers for Financial Planning magazine, showing how correlations between asset classes can change. He found that from the beginning of 1979 through the first quarter of 2007, there were 81 up-market quarters—arbitrarily defined as when the New York Stock Exchange Composite Index was up at least 0.5%—and 25 down quarters, with drops of at least 0.5%. For each quarter, he looked at the correlations among 10 asset classes. "In general, you don't want low correlation when the stock market is going up, but you want a safety blanket in down markets," says Gambera.

Surprisingly, the numbers showed that real estate investment trusts, which have long been touted as great diversifiers, didn't always perform as expected. "REITs had low correlations to stocks in up markets, but much higher correlations in down markets," Gambera says. As a result, he says that REITs may be an attractive asset class for long-term returns, but "yields are low and other diversified bond portfolios offer good yields with less risk of price losses," he observes. Investors seeking diversification and cash flow might also look at high-yield bonds, which have been more correlated with stocks in up markets and less correlated in down markets.

Financial Planning compared the performance of high-yield bonds and REITS to the Standard & Poor's 500 Index, using Vanguard funds as a proxy, for the four weeks ended August 13. During this period, Vanguard's S&P 500 Index fund lost 6.27%, and its REIT index fund dropped 8.62%. The High-Yield Corporate Fund, by contrast, was 1.54% ahead. Score one for noncorrelated assets.

"The correlation of asset classes changes over time," says Greg Morris, senior portfolio manager at PMFM, an investment advisory firm in Watkinsville, Ga. "You need to ensure that you are dealing with up-to-date mathematical correlation and not assume that what was true in the past is still true today."

For example, in 2004, the 24-month correlation of monthly price changes in the S&P 500 and EAFE indexes hit .92, says Brian Gendreau, investment strategist for ING Investment Management in New York. (Perfect correlation has the numerical value 1.00.) "Since then the correlations have come down quite a bit. The EAFE/S&P 500 correlation is down to .61 and the emerging markets/U.S. correlation fell to .74."

International small caps are even less correlated with the S&P 500, he adds. Recently, in general, correlations have come down between the U.S. and developed markets. "The U.S. economy and monetary policy is out of phase with many other major countries, which are growing faster," he says. More rapid growth, and in some cases divergent interest rate movements, may shake stock markets out of lockstep.

A basic portfolio, says Gambera, might be mainly invested in stocks and bonds, with stocks allocated 70-20-10, large cap to mid-cap to small cap. "We feel that 30% of an investor's equities should be in international stocks, including some in emerging markets," he adds. A baseline fixed-income allocation might be 90% in investment-grade bonds and 10% in high-yield bonds, diversified among various durations. Among fixed-income holdings, 15% to 30% might be in foreign bonds, with allocations toward the higher end when bearish on the U.S. dollar and lower when bullish.

Commodities

Because correlations in a long-running bull market are substantial, there is always the risk that a break in one stock market could spread, causing a wider crash. For protection against such a down market, Gambera also suggests putting 5% to 10% of a portfolio into natural resources, including precious metals. Gold, for example, has had a negative correlation to stocks in down markets, although lagging long-term returns dim its luster. "You might want to include a commodities index fund with exposure to energy because rising oil prices may be one cause of an economic recession," he says. If such a recession socks the stock market, an energy-skewed commodities fund might serve as a partial offset.