by Brad Case

The German statesman Konrad Adenauer was quoted as saying We all live under the same sky, but we dont all have the same horizon.

Thats certainly true of investors: We all live among the same set of assets, but how we combine them into an investment portfolio depends on our own circumstancesincluding our investment horizons.

To simplify, we might say there are two types of investors. The first typecall them tacticalpays attention to short-term fluctuations, hoping to identify opportunities to buy undervalued assets or to sell overvalued ones. Tactical investors play an active role in identifying mispricings and trading in a way that tends to eliminate them. For tactical investors, correlations among asset classes are less important than current valuationsand volatility may actually be good, because it creates trading opportunities.

The second type of investorcall them strategicdoesnt have time to look for short-term mispricings; instead, they structure a well-diversified portfolio and take advantage of the interactions among their assetsthat is, the power of diversificationto reduce the likelihood of a hit that would affect the entire portfolio. Strategic investors have a long investment horizon: Current valuations are less important than low long-term correlations and strong long-term risk-adjusted returns.

Its not surprising that the investment characteristics of particular assets change over time: For example, return volatility for publicly traded real estate investment trusts (REITs). along with most or all other assets, spiked during the credit crisis of October 2008March 2009. (REIT volatility rapidly declined to normal levels after the crisis ended, however.) What is more surprising, though, is that investment characteristics may also change over different investment horizons. If thats the case, then you can potentially make better portfolio decisions by understanding investment characteristics at your own most relevant horizon.

Stock Correlations Move Closer Over Time

As an example, Figure 1 shows correlations between the telecommunication services sector of the U.S. stock market and two measures of returns to the broad stock market, the Wilshire Total Market index and the S&P 500 index of large-cap stocks. [Correlation measures how closely two variables tend to move in relation to each other.] All of the correlations are computed over the same historical period, from January 1990 through November 2011but theyre computed over differing investment horizons ranging from one-month returns to 60-month returns. [All sectors are represented by the S&P Global Industry Classification Standard (GICS) series of sector total return indexes.]