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 and negatively correlated asset classes should reduce the overall volatility of the investment and yield a consistent ROI in the long run.
Learn from our article the essentials of negative and positive correlation between asset classes and answer the questions in the following:
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 measures how one asset class is connected to another to evaluate whether they move in the same direction or not. For example, 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 would react the same way. This is because the S&P 500 relies on the benchmark of all the correlated assets. Cash, on the other hand, does not correlate with the other asset classes, except bonds because it is not reliant on any other assets.
Investing in assets with a negative correlation will not always produce a gain. However, allocation amongst non-correlative assets still gives you a better chance of diluting the risks. Although more asset classes may provide a better opportunity for non-correlation, it may end up costing 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. A positive correlation is measured on a scale of 1.0, meaning it is positively correlated. A negative correlation is measured on -1.0, meaning if one asset gains, the other loses. A neutral correlation is measured on 0, meaning the assets are not impacted by each other no matter the market condition. 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 visualizing tools show asset class correlations that are easily accessible to everyone.
Firstly, achieving a true zero correlation between assets is rare. Secondly, correlation is not stable - meaning it changes according to market conditions. An asset that did not influence another previously could be impacted now. For example, 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 globalized, 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:
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