In recent years and especially since 2008, correlation
among various asset classes has become a hot topic. Basically, correlation is
how an investment moves in relation to other investments.
In short, correlation measures how closely two variables
move together over time. For example, two pharmaceutical stocks often have a
high degree of correlation because the same forces influence their share prices.
In contrast, gold stock prices are not closely correlated with pharmaceutical
stock prices because the two are influenced by different factors. Therefore,
ideally when building a diversified portfolio to minimize risk, an investor
would want mutual funds or even individual equities that will perform
differently from each other in any given type of market.
In general, a high correlation is considered to be .70, a
moderate correlation is considered to be .50 to .70, while 0.3 generally is
considered to be relatively "uncorrelated". A perfect positive
correlation would be 1.0, while 0.0 would be perfectly uncorrelated, and -1.0
would be perfectly negatively correlated. The closer the ratio is to 1.0, the
more closely the rates of return will move in conjunction with one another. Very
close positive correlation would be what investors could expect among several
index funds whose goal is to match the same underlying index such as the U.S.
Very few pairs, let alone groups of investments, such as
mutual funds move in exact tandem with each other or, for that matter, totally
opposite of one another. Most are somewhere in between. The key to building a
good asset allocation portfolio is combining investments in a portfolio that
have low or negative correlation with one another. Ideally, one would like each
investment to have low correlation with each other regardless of how many
investments that they have.
The anti-thesis of building a portfolio with low
correlation investments is the thought process that many investors and advisors
falsely have, which is that when they buy several different large company mutual
funds in the same portfolio that they are diversifying. In fact, such a strategy
does not reduce risk, or at best minimally so. This is simply because most large
company mutual funds react the same way to stock market movements and are
therefore highly correlated due to the fact that they own many of the same
underlying equities or ones in the same industries in similar proportions.
Combining investments with low or negative correlations to one another allows
the portfolio to protect itself and as a result, insulate itself from financial
Frequently, investors and many advisors assume that a
portfolio comprised of 100.0% bonds is very conservative and has very little
risk. This is not necessarily true! If interest rates rise, bonds very well
could deliver losses. A portfolio holding 70.0% to 75.0% bonds and 30.0% to
25.0% equities potentially could provide an investor with increased returns for
slightly less risk than an all bond portfolio. Separate mutual funds that invest
in money market securities, currencies, commodities, real estate, hedge
strategies, managed futures and limited partnerships when mixed together with
traditional equity and bond investments can reduce volatility even further.
Ultimately, such combining and equally weighting
investments that move in dissimilar ways can reduce the volatility of a
portfolio while delivering potentially smoother returns than the stock market
itself. This type of strategy is a basic building block of a lower volatility