The Basics: Correlation

On your journey to investing enlightenment you will encounter
many pearls of wisdom. For example: “There
is no free lunch”
or “if you want
greater return, you need to accept greater risk.”
 The relationship between risk and return is Investing
101, Chapter One – shifting the focus from solely returns and widening the view
to consider volatility. If you are only making a single investment, it might be
sufficient guidance on its own.

Then we get to Investing
101, Chapter Two: “don’t put all your
eggs in one basket.”
This investment axiom is perhaps the oldest and best
known. In my opinion, it is a little off base. I think it’d be more apt to say:
don’t put only eggs in your basket.” As we look for the next investment
to add to our basket, we need to broaden our criteria. Yes, we should always seek
a favorable risk/reward profile. But we also must consider the interactions
between the various eggs in our basket. In portfolio manager language, this translates
to a search for investments with a low correlation
– selecting investments that complement and offset each other’s behavior. Should
one investment lose value in certain circumstances, the other investment may be
poised to gain value under the same circumstances. Unfortunately, as the prior
sentence demonstrates, there are no snappy analogies or pithy slogans for correlation.
However, it is a critical concept when building a portfolio of investments.

Evaluating the correlation between two investments can be a
tricky matter. We tend to rely on past behavior as a guide. Have the proposed investments
historically reacted differently and offered diversification benefits? In fact,
it matters more how investments behave relative to each other in the future. The relationship between
different investments can fluctuate over time, defying historical standards or
rules of thumb. Recent market behavior offers a good example.

Historically, stocks and bonds have shown a very low
correlation. When stocks values rise sharply, bonds tend to sell off – and vice
versa. However, in recent months, stocks and bonds have increased in value
together. While there are many contributing factors for this behavior, the
question is: how long will this “togetherness” last, and how do we defend against
both stocks and bonds falling in
tandem?  One solution would be to look
for other investments that offer low correlation to both stocks and bonds. Cash, or a money market fund, is one
example. Although cash offers very little risk and very little return, it also
offers very little correlation to both stocks and bonds. Other examples are commodities,
real estate, and precious metals.

Broadening the available investment universe and focusing on
risk, return, AND correlation is valuable advice – while not entirely catchy. For
most investors, the goal is to maximize the return of the portfolio for a given
level of risk. It is essential to remember that controlling the level of risk requires
a continued focus on the correlation of investments in the portfolio.

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