Definition of Correlation
Investing correlation is a measurement of the relationship between two or more assets and their dependency. The correlation measurement is expressed as a number between +1 and -1.
A zero correlation indicates there is no relationship between the assets. A +1 indicates an absolute positive correlation (they always move together in the same direction). A -1 indicates an absolute negative correlation (they always move together in opposite directions of each other).
In our next post we examine “Examples of Correlation and Potential Problems with Asset Correlation”.
Why is Correlation Important?
The concept of asset allocation is based on combining assets that have low or no correlation. The purpose of strategic asset allocation is to lower portfolio risk and optimize portfolio returns. Asset allocation only works if you combine asset categories in the portfolio that have a low correlation. By putting low correlation and/or negatively correlated investments in a portfolio the overall volatility (risk) of the portfolio is lowered.
Portfolio Optimization – Combining asset categories that have a low correlation reduces the risk of the portfolio as a whole and allows the portfolio manager to invest more aggressively. In other words a portfolio manager, willing to take a given amount of risk, can invest in higher return/risk investments because the risk of the overall portfolio is lower due to combining non-correlated asset categories.
Understanding correlation and asset allocation can reap huge rewards for your portfolio. Just as I showed in “How the Expense Ratio of Mutual Funds Hurt Investment Performance” that a 1% difference in expenses can cost a $100,000 portfolio a whopping $146,000 over a 30 year period. The opposite is true here. If you can increase your portfolio returns by 1% annually on that same $100,000 portfolio it will return you an extra $146,000 over a 30 year period.
Small differences in rate of return can make gigantic differences in portfolio values in the long term. Implementing sound investment concepts that reduce risk and increase portfolio returns is a crucial part of successful investing.
What do think about the concept of asset allocation and correlation?
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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