- Asset correlation is related to diversification and is another area that J. Bradford Investment Management helps add value to client portfolios.
- Correlation helps us determine how "related" to one another two investments or two portfolios are.
- Understanding the correlation between assets in your portfolio can help ensure the right level of risk and and ensure the right level of exposure to desired markets and asset classes.
If you have a portfolio of assets that all move in the same direction and to the same general magnitude (e.g. all of the assets in the portfolio go up 10% together) the diversification benefit might not be as strong as you'd hoped. This correlation problem was exaggerated in 2008 when most asset classes decreased in value and decreased significantly all at the same time.
To combat this, we look for assets that are not strongly correlated with each other or a benchmark we are trying to diversify from. This is a post 2008 correlation matrix of several popular ETFs that generally represent the asset class they are in. This chart purely illustrative and for educational purposes only. This material is NOT a recommendation to buy or sell any of these securities. Charts produced using the Portfolio Visualizer tool from Silicon Cloud Technologies.
A value of 1.0 means the two are perfectly positively correlated. If one goes up 10%, the other goes up 10% as well. A value of -1.0 means the two are perfectly negatively correlated. One goes up 10%, the other goes down 10%. A value of -0.31means if one goes up 10%, the other goes down 3.1%. Over this time period, you may be surprised to learn that VTI, VO and VB ( a small cap ETF, mid cap ETF and all cap ETF) all had a correlation with each other very near 1.0 and would have offered little diversification benefit over this time period. Even the international EFT, VEU was very highly correlated with the U.S. Market. The big opportunities over this time period to diversify were in bonds and commodities.
Just like we don't know ahead of time what the performance or risk or any asset or portfolio will be we don't know in advance what the correlation between two assets or two portfolios will be, which is why portfolio construction is not an exact science.
Many professionals use historical correlation information as a guide, but also combine that information with existing capital market expectations, diversification strategies, risk management strategies, risk and return analysis, independent research and professional judgement to build portfolios.
If you want to discuss a correlation analysis of your portfolio or any other financial topic that matters to you, schedule a free consultation today.