A good investment portfolio consists of spreading risks in asset classes with little to no correlation. A positive correlation is where two asset classes move up or down simultaneously because they are relative to one another. A negative correlation refers to where one asset falls; the other moves up. A zero correlation is where no assets impact one another in any conditions and is an ideal investment portfolio. While you cannot eliminate risks completely, diversifying your portfolio between non correlated asset classes and negatively correlated asset classes should reduce the overall volatility of the investment and yield a consistent ROI in the long run.
Asset class refers to a group of investment vehicles that share similar characteristics. Different classes, or categories, of investment assets are classified together based on their financial structures being comparable. They are governed by the same set of rules. In this article, we will explore the correlation, both positive and negative, between asset classes in the following:
Asset class is a collection of similar financial instruments with similar risk characteristics. Investment vehicles are viewed by financial advisors as asset class groupings that are utilised to diversify portfolios. Each asset class is expected to represent different risk and return investing characteristics and perform differently. The aim of understanding asset classes is to diversify portfolios by combining assets from different categories to minimise risks.
Although there is no standard count on the types of asset class, most analysts have split asset classes into five main categories:
Some assets are difficult to categorise. The wide range of investing options further adds to the complexity. ETFs (exchange-traded funds) are similar to stocks in that they trade on exchanges. They can be made up of investments from any of the asset classes (e.g. oil company equities included in an ETF for exposure to the energy industry).
Location can also be used to categorise assets. Domestic securities, overseas investments, and developing market investments are frequently viewed as separate asset groups by market experts. Hedge funds or private equity investments, peer to peer lending, collectibles, and cryptocurrencies are among the less well-known asset groups. As a result, they're commonly lumped together under the term "alternative investments."
An investment portfolio should ideally include a well-balanced mix of investments from several asset types, such as equities, bonds, and gold. Each of these assets has a distinct role in your portfolio, offering growth, income, relative stability, and inflation protection. Equities, fixed income, and cash equivalent or money market instruments have historically been the three most popular asset classes. Real estate, commodities, futures, other financial derivatives, and even cryptocurrencies are now included in the asset class mix by most investing experts. In fact the top assets by market cap are gold and silver, tech stocks, oil and natural gas, and to some extend cryptocurrency.
No asset class is free from risk. Each of them has its own categories of risk. For example, even though cash is considered to be the safest asset to have, it is not free from risk. The kind of risk cash is prone to is inflation. Nevertheless, there is a form of consensus when it comes to agreeing which asset classes are the riskiest:
An investing strategy is how one invests in a certain asset class for the best possible outcome, and there are numerous ways to do it. Growth, value, income, and a range of other elements can be used to identify and categorise investment strategies. The most commonly agreed upon investment strategies are:
Most investors think that their portfolio is sufficient simply because they have considered various asset classes. However, it is not the number of asset classes that make a portfolio diversified. Rather it is the ROI balanced with risk that is important for the portfolio, and asset class correlation is one way to determine that balance.
Asset correlation is used in order to determine if two asset classes are moving in the same direction. There are positive correlations, negative correlations and neutral correlations. A neutral correlation means that the assets are not impacted by each other no matter the market condition.
Although more asset classes may provide a better opportunity for non correlated investments, it may cost you more if you blindly add newer ones without researching the relativity.
Unfortunately, there is no straightforward way to measure correlation. Determining asset correlation relies on complex mathematical formulas that merely aids financial analysts to evaluate asset class. Even then, the calculation is subject to market change. Two assets that had little correlation 5 years ago maybe more reactive to each other now.
Fortunately, many online visualising tools show asset class correlations that are easily accessible to everyone.
A positive correlation refers to the situation where if one asset class reacts in a certain way, whether positively or negatively, another asset class will react in a similar way. Examples of positively correlated assets include the S&P 500. S&P 500 has the highest positive correlations with REITS, Equities, hedge funds, and global securities. If one of them moves up or down, the S&P 500 will react the same way. This is because the S&P 500 relies on the benchmark of all the correlated assets. A positive correlation is measured on a scale of 1.0.
A negative correlation is measured at -1.0. A negative correlation refers to the opposite situation where if one asset class reacts positively or negatively, another asset class will react in the opposite matter - meaning if one asset gains, the other loses. A negative asset correlation is not permanent, though, as market conditions may change the correlation between two asset classes. Investing in assets with a negative correlation will not always produce a gain.
There are very few examples of permanent low correlated investment classes. General examples of negative correlation are stocks and bonds, but even that may turn into a positive correlation. Another example is cash, as it does not correlate with the other asset classes, except bonds, because it is not reliant on any other assets.
Firstly, achieving a true zero correlation between assets is rare. Secondly, low correlation asset classes are not static - meaning it changes according to market conditions. An asset that did not influence another previously could be impacted now.
Let's start with an example to understand fluctuation of correlation. Historically, bonds had little correlation to stocks in their past performance. However, recent studies have shown that bonds are becoming closer to stocks in terms of their impact. International stocks, which were not influenced by domestic currency stocks, are now reacting to US stocks. This is because everything is globalised, and companies are no longer operating in a single country.
Not all assets react the same way to market changes (e.g. cash reacts differently to inflation than gold). For example, European stocks and oil were negatively correlated - so if the oil prices fell, the value of European stocks rose. However, this relationship changed by the end of 2015 when the relativity relationship became the opposite - meaning now, stock prices would also fall if oil prices decreased. This happened because oil has an economic impact on countries, and oil is a major portion of the stock market. Therefore, if a country faces a recession, oil prices will crash, and their stockholders will also suffer losses. They will sell whatever stocks they hold to cash out, driving the prices further down. This is a natural reaction to an economic event. Financial analysts work tirelessly to figure out the most recent correlation of assets to ensure that their clients' portfolios remain stable.
You cannot truly hedge against positive correlations, and achieving zero asset correlations is near to impossible. Instead, you can utilise the asset correlations, positive, negative, and neutral, to minimise the potential losses. Here we discuss the ways you can utilise assets with all correlation types to enhance your investment portfolio:
If you know the correlations between any of your assets, you can better diversify your portfolio and reduce volatility. Understanding asset correlation can also assist active traders identify trades and devise strategies. In order to acquire a better understanding of the market as a whole, it is helpful to look at asset correlation. When the market is exceptionally volatile, it is generally a good idea to understand asset correlation to determine your investment tactics.
Correlation can help you to better comprehend risk since it compares the potential return on a portfolio's various assets to the risk associated with that portfolio's various assets. However, the correlation coefficient has low predictive power for individual stock returns. Modern portfolio theory has the flaw of assuming that asset correlations are static throughout the time when in fact, they are dynamic and ever-changing. While investors can benefit from a better understanding of correlations by constructing more diverse portfolios, correlation coefficients don't really indicate much beyond that.
Understanding positive and negative asset classes correlation is important to determine your asset allocation and your portfolio diversification. Depending on the asset class and their relationship with each other, your investment strategy will be different. An ideal portfolio would have assets with little to no correlation. However, under globalisation, where all assets react to each other in some way dynamically, it is difficult to achieve the ideal portfolio permanently. The adjustment from time to time is required as the correlation changes over time. However, while not static, the correlation will give you an overview of the market and help you make the minimum adjustment needed to keep your portfolio healthy.
Asset correlation helps investors foresee future trends and manage their portfolio risks accordingly. With various tools online, it has now become easier than ever to calculate asset correlation and its fluctuation. To ensure the efficiency of the portfolio, investors need to understand the relationship between the asset classes to determine whether they are reliant on each other or not. Investors need to observe the changing relativity between the assets in the market. Lastly, after learning how the assets work and react, investors can optimise the correlations in the portfolio.
Last update: 10/08/2021
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