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.
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.
Note
Alternative asset classes, such as hedge funds and private equity, have a less consistent correlation since it depends on variables like the specific goals and fund managers. However, many of these investments are available only to the wealthiest accredited investors.
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.
Note
A helpful resource from Portfolio Visualizer shows a correlation matrix for typical asset classes and subclasses. This is just one example of the tools available to assess correlation.
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.
Frequently Asked Questions (FAQs)
What is the correlation of a risk-free asset?
A risk-free asset has a largely stable value, which means its price is unlikely to move significantly up or down at any point. Therefore, its correlation to any other assets would be zero. When another asset goes up, the risk-free asset will probably remain the same. When another asset goes down, the risk-free asset will probably remain the same.
What is the purpose of analyzing asset correlation?
Understanding the correlation of any assets you own can help you diversify your portfolio and reduce volatility. For active traders, understanding asset correlation can also help you target trades and develop strategies. For example, when an asset develops an uptrend, you may want to target bullish trades in correlated assets or bearish trades in negatively correlated assets.
