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When you first start investing, it can be difficult enough to understand what your investments are and how they work — let alone how they interact with one another. But it’s helpful to understand the relationship between different investments and how they act in relation to other assets.
Asset correlation is especially important to understand when you’re working to build a diversified portfolio. Keep reading to learn more about how asset correlation works, how it’s measured, and why it’s essential in building your investment portfolio.
What is Asset Correlation?
Asset correlation is a measure of how different investments move in relation to one another. Two assets that move in the same direction simultaneously are positively correlated, while those that move in opposite directions are negatively correlated. Some asset pairs have no correlation or relationship at all, which means they don’t tend to move with or against each other.
How to Measure Asset Correlation
Asset correlation is measured on a scale of -1.0 to +1.0. Not only does the scale measure whether two assets are correlated, but it also measures how closely related their movements are. The further to one side of the scale an asset falls, the stronger the positive or negative correlation.
For example, two assets with a correlation of +1.0 are perfectly correlated, meaning they always move in the same direction at roughly the same percentage. And if two assets are -1.0, it means they’re perfectly negatively correlated. They’ll always move in opposite directions at the same amount.
Finally, two assets with a correlation of 0 have no relationship whatsoever. The movement of one of the assets doesn’t necessarily mean the other will move or predict what direction it will move if it does.
A mathematical equation is used to calculate the correlation between two or more assets. The most common formula uses the covariance and standard deviation of each asset. However, a more straightforward way to measure it is by using an asset correlation calculator online. These calculators automatically calculate correlation using two stocks’ ticker symbols.
Asset Correlation Examples
To give you a greater understanding of asset correlation, let’s discuss a few examples of asset pairs that have positive correlations, negative correlations, and no correlation at all.
As we mentioned, a positive correlation between two assets means that they move in the same direction at the same time. And the more closely correlated they are, the more similar their movements are.
For example, if a stock gains 5% and is perfectly correlated to another stock, that other stock would also gain 5%.
Assets within the same industry are likely to have a high positive correlation since they’re affected by similar market factors. For example, two auto manufacturers in the United States would likely have a high positive correlation.
When assets negatively correlate, they tend to move in opposite directions. More strongly negatively correlated assets will be further apart from each other. For example, if two assets have a perfect negative correlation, when one gains 5% in the market, the other will lose 5%.
In our example of positive asset correlation, we looked at two companies’ stock prices in the same industry. To find examples of negative correlation, it makes more sense to look at two entirely different assets: Stocks and bonds.
When stock prices increase, investors tend to move away from bonds and look to the stock market. But when the stock market is down, investors tend to turn to bonds. Because of their negative correlation, investment experts recommend having both stocks and bonds in your portfolio. This allows you to hedge your risk no matter which way the market moves.
When two assets have zero correlation, it means they have no relationship with one another whatsoever. In these cases, it’s impossible to predict the movements of one asset based on the movement of the other.
In reality, it’s difficult to find assets with zero correlation. The effects of the overall market tend to affect other markets. However, certain assets may be less likely to be correlated with the overall market. Those assets can include real estate, commodities, art, and more.
Cash is another asset that rarely correlates with others. This is why many experts recommend keeping a portion of your portfolio in cash at all times in addition to investments that may have a correlation with one another.
Asset Correlation and Modern Portfolio Theory
Modern portfolio theory is a common investment strategy that seeks the perfect balance between portfolio risk and return. This theory is based on the premise that the market is generally efficient and that it doesn’t make sense for investors to forecast future investment returns or pick individual stocks. Instead, modern portfolio theory stresses the importance of diversification to minimize portfolio risk.
Asset correlation and modern portfolio theory are closely related. In fact, modern portfolio theory relies entirely on the premise that different investments have different relationships with one another.
When you follow modern portfolio theory, you include some assets that are positively correlated, some that are negatively correlated, and some that have no correlation at all. This way, no matter what happens with the market you’ll have some investments in your portfolio that perform well (along with the ones that perform poorly_.
Modern portfolio theory and asset correlation are useful tools for creating a well-diversified portfolio that can survive any market, but it’s not a perfect science. When we talk about perfectly positively- and negatively-correlated assets, we might assume that those assets will always have the same relationship. But that’s simply not the case.
Today’s market especially is unpredictable, so the correlation between different assets can change. That’s not to say you shouldn’t keep asset correlation in mind when building your portfolio. Just remember that the correlation between two assets isn’t fixed.
Is Asset Correlation Important?
Understanding how asset correlation works is an important step when you build your investment portfolio, especially when it comes to market fluctuations and downturns.
Again, an important example of asset correlation is the relationship between stocks and bonds. Most investment experts recommend including both asset classes in your portfolio. In fact, there are formulas for determining what percentage of your portfolio should be allocated to bonds. Some experts recommend a 90/10 stock to bond ratio. Others recommend subtracting your age from 120 and allocating that percentage of your portfolio to stocks.
As an investor, you’ll understand just how important asset correlation is when you experience your first market correction. It’s easy to panic when you see your stock market investments lose value. But because of what is often a negative correlation, you may notice that your bond investments are actually doing well.
It’s also important to note that correlation doesn’t always equal causation. Certain assets may tend to move in the same direction. But that doesn’t mean that the movement of one of the assets causes the movement of the other. It’s more likely that similar factors caused both assets to move. On the other hand, when two assets are negatively correlated, the positive movement of one doesn’t necessarily cause the negative movement of the other (though it could).
The Downside of Asset Correlation
The downside of relying on asset correlation when building your investment portfolio is that, as we mentioned, the relationship between two assets can change. Assets that once had a negative correlation can eventually come to have a positive correlation, and vice versa.
Understand that there are no guarantees. And you’re even more likely to see changes in the correlation between two assets in volatile and unpredictable markets.
It’s also difficult to predict how new assets will play a role in asset correlation. For example, cryptocurrency has become popular even during a time when the stock market is doing well. However, its performance has been volatile. And the jury is still out regarding whether it’s correlated to other assets and in what ways.
Asset correlation describes the relationship between two investments. It’s an important concept to understand when you’re building a portfolio as it can help you choose your investments in a way that strikes the right balance of risk vs. reward.