Asset Correlation: What Is It and How Do You Use It?
Asset correlation is the measure of how assets move in correlation to one another. Highly correlated assets move in the same direction at the same time, while negatively correlated assets move in the opposite direction from one another — one moves up as the other moves down.
The theory of asset correlation is that you can reduce risk and increase returns by investing in asset combinations that are not correlated. The basic rule has been that equities go up when economies perform better, and bonds perform better when economies go down. Their low correlation to one another is why this has been effective over the years.
Having a mix of bonds and stocks in portfolios has always been a basic investing concept; but today’s market is not as predictable or stable, and the way they move is changing. Recently, bond markets have become more highly correlated to equities.
This change in correlation has become a new risk factor investors need to think about when developing their asset allocations. It’s not just about the percentage of bonds in your portfolio anymore, but the types of bonds as well. The new thinking is that you have to plan your investment strategy around volatility because of the change in bond behavior.
Diversification Is Still the Key
With correlations increasing among equity classes, investors need to be diligent about their portfolio strategies to ensure sufficient diversification. You may want to do some research on your portfolio to see how your asset correlation has shifted over time, so you can focus your rebalancing efforts on these fluctuations.
The bottom line is that traditional asset allocation must be done in a smarter way to reduce risk and increase returns in your portfolio.
Please call if you’d like to discuss asset correlation in more detail.