Keep reading to learn more about asset correlation and how it can help inform your investment choices.
Measuring Asset Correlation
A correlation of 0 means that the returns of assets are completely uncorrelated. If two assets are considered to be non-correlated, the price movement of one asset has no effect on the price movement of the other asset.
Correlation and Modern Portfolio Theory
Under what is known as modern portfolio theory, you can reduce the overall risk in an investment portfolio and even boost your overall returns by investing in asset combinations that are not correlated. In other words, you own assets that don’t tend to move in the same way at the same time. If there is a correlation of zero, then there is no correlation and one asset’s direction does not determine another asset’s movement. If there is a negative correlation, one asset will go up when the other is down, and vice versa. By owning assets with a range of correlations to each other, you can maintain relative success in the market—without the steep climbs and deep dips of owning just one asset type. When one type of stock is performing well, your gains may not be as high as your neighbor’s that is totally invested in that asset, but your losses won’t be as extreme if that same asset starts to experience a downturn.
Correlation Can Change
The correlation and non-correlation theory makes good sense, but it was easier to prove when investments were generally less positively correlated. Modern markets are not as predictable, not as stable, and they constantly change the ways in which they move. While bonds once had a somewhat reliably negative correlation to stocks, that correlation has spent more time positive than negative since the turn of the century. Similarly, international stocks are now more closely impacted by the U.S. stock market. Most companies are global and not isolated to one particular country or region.
How to Get Non-Correlated Assets
Diversification is one way to get close to achieving non-correlation. True non-correlation is rare these days, and there are financial experts who work full time in the attempt to find the most efficiently non-correlated portfolio possible. For most of us, holding a combination of stocks, bonds, and alternative assets like cash and real estate over the long term will do the trick. These assets all tend to perform in a less-than-correlated-way, and in combination, can help dampen the overall volatility of a portfolio. Gold is also known to have a non-correlation with stocks.
Does Diversification Make Sense?
Despite investments becoming more highly correlated, smart diversification can still reduce the risk and increase the return of your portfolio. Assets still tend to perform differently, and the gains of one still cushion the losses on another. By finding a mix of investments that suits your risk tolerance and long-term investment goals, you’ll be the holder of a very modern portfolio.
How to Research Correlation
Many different tools and resources are available to help you research asset class correlation using popular ETFs and asset class benchmarks. Generally speaking, the lower or more negatively correlated certain asset classes are to each other, the more diversification benefit of having those asset classes in an investment portfolio.
