What Is Correlation and How Can It Impact the Volatility of Your Portfolio

Thursday, September 1, 2011

 

Correlation is defined as the tendency of different investments to move in synch with each other. Measured on a scale of -1.0 to +1.0, a correlation of +1.0 means two investments move in perfect tandem with each other. In other words, when investment A zigs, investment B also zigs. At the other end of the spectrum, a correlation of -1.0 means two investments move in opposite directions. Otherwise stated, when investment A zigs, investment B zags. To reiterate, correlation is a statistic representing how closely two variables tend to move together.
 
The reason correlation is an important term, is because it is an important tool in portfolio construction. We find that in evaluating different investment options for their portfolios, most investors focus on past total return. Very little time, if at all, is spent evaluating how a new fund or security correlates with the other holdings in the portfolio. This can result in portfolios that may have several different funds or securities, but in reality little diversification because all of the holdings correlate close to +1.0. In the past, or in bull markets, investors could check off all of the boxes and assume they were adequately diversified, right? Wrong! With correlations of 0.900 or better, the nine common investment style boxes all move more or less in sync. This is actually contrary to diversification and can give investors a false sense of security.
 
For added diversification, you may want to consider a portfolio made up of not only traditional equities but also real estate, commodities, managed futures, non-dollar holdings and other alternative asset classes. Each of these investments has a return profile in its own right, but more importantly typically generate returns with lower correlation to traditional equities. Fixed income and cash have lower correlations as well.
 
This correlation focused approach to asset allocation could mean more diversification over a full market cycle. One caveat of correlation analysis is that it is based on past return relationships between asset classes. The correlation relationship that held in the past may not hold in the future.
 
In our wealth management practice at Ancora, we spend a significant amount of time researching and building portfolios that have diversified sources of returns. Correlation analysis is at the core of that portfolio construction process. If you would like to discuss the concept of correlation in greater detail or have us review your current portfolio in the context of its correlation features, please feel free to contact us.