Correlated and Non-Correlated Assets
Why Asset Correlation Matters for Your Investments
Asset correlation is a measure of how investments move relative to one another. When assets move in the same direction at the same time, they are considered to be positively correlated. When one asset tends to move up when the other goes down, the two assets are considered to be negatively correlated. Assets that don't show any relationship to each other are non-correlated.
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. Meaning they don't tend to move in the same way at the same time.
If there is zero correlation or negative or non-correlation, one asset will go up when the other is down, and vice versa. By owning a bit of both, you do pretty well in any market, without the steep climbs and deep dips of just one asset type. Your highs may not be as high as your neighbor's, but neither will your lows be as low.
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 are changing the way they move. Many financial experts agree that correlation seems to have changed following the financial crisis of 2008.
The correlation to stocks to everything but US Treasuries increased sharply in 2008-2009. Post-crisis, Treasuries are now positively correlated when they once were negative.
International stocks and bonds used to move in the opposite direction of US stocks and bonds, but these days, one global market can quickly impact another. Most companies are global and not isolated to one particular country or region. The correlations between U.S. and international stocks has increased in recent years.
The correlations of junk bonds and stocks have increased in recent years as well. Small-company stocks that are just starting, and even emerging markets stocks, have traditionally been non-correlated with larger-company or established market stocks.
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, perhaps some 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, too, is known to be non-correlated with stocks. It makes sense when you think of people running to the safety of gold when the stock market is volatile.
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. So, find a mix of investments that suits your risk tolerance and long-term investment goals. You'll be the holder of a very modern portfolio.
Many different tools and resources are available to help you research asset class correlation using popular ETFs and asset class benchmarks. A resource from Portfolio Visualizer shows a correlation matrix for typical asset classes and subclasses. 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.
The content on this site is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.