by WWM | Jun 21, 2017 | Returns
In our first look at investment returns, we reviewed a few common return calculations.
If you know the formulas, the calculations are quite simple. But the key is to understand what is included and excluded between the different returns. That allows for apples to apples comparison when analyzing returns.
But even in standardizing quantified calculations, investment returns can mean different things to different investors.
Today we will consider some of the qualitative aspects in evaluating investment returns.
Return, like risk, is in the eye of the beholder. Never be seduced simply by the quantitative side of investment returns. Always look at results from other angles as well.
I think this is just as important as the hard numbers. Unfortunately, it is an area many investors ignore to varying degrees.
Do so at your own peril.
Expected Rate of Return
Before we get into today’s session, I quickly want to review a topic we have previously discussed.
Expected return is the anticipated asset performance for the future period under consideration.
There are a variety of ways to calculate expected returns and most incorporate multiple variables.
Historic returns, probability and scenario analysis, company specific expectations, general market and industry specific expectations, risks, risk-free returns, etc. There are many factors that go into determining an asset’s expected return.
Because these returns are expected, there is a probability that the actual results will differ.
This is where our earlier discussions of standard deviations come into play. The larger the standard deviation (i.e. the greater the volatility of the asset), the less likely that the actual return will equal the expected return.
As the level of risk lessens, the certainty of the result rises. It is only in investments that have no risk that the expected return will always match the actual nominal return.
In our analysis below, we shall use this simple example.
You invest $1000 in an asset on January 1. You sell the asset December 31 for $1250. There were no cash flows so your total return (also, in this example, your holding period and annual returns) is $250 or 25%.
Nominal Rate of Return
While expected returns are forward looking, nominal returns reflect what actually occurred.
This is the most common way to express a return.
The nominal return is the investment return unadjusted for any other factors. In our example, the nominal return is 25%.
25% return in one year sounds great! Does it to you? Sure it does.
Let’s not be so hasty. There are a few more paragraphs on the page to read.
Nominal return is a good number to know. But on its own, there is no context.
We always need context. Well, at least those who want to properly invest do.
How do we put nominal returns in context? You need to use comparative data.
Real Rate of Return
The real rate of return adjusts the nominal return to eliminate any impact from inflation.
We discussed the affect of inflation previously.
Let’s say that your investment above was made in the United States where the annual inflation rate is running at 3%. Your real rate of return therefore is only 22% (25% nominal minus 3% inflation).
Not too significant an impact. An American attaining that return is likely smiling.
However, perhaps you live in Argentina where inflation is about 27% annually. Your real return becomes a loss of 2%. Even though you made a 25% profit (on which you will be taxed, so your net will be much less), you have actually lost 2% in purchasing power over the year.
For an Argentine, is 25% nominal return good? Not when actual purchasing power erodes that return to nothing.
Or we could consider Venezuela where inflation hit 800% and experts are predicting 1600% in mid 2017. Suddenly, a mere 25% gain will not even help you buy toilet paper (assuming you can even find any in Venezuela currently).
A Venezuelan achieving a 25% return will not be happy at all.
You need always consider the impact of inflation on your returns. Its impact on your real returns can be substantial. And depending on the inflation rate, may make a potentially nice nominal return much less attractive.
Risk-Free Rate of Return
The risk-free rate of return is the return on an investment that carries no risk.
That is, the outcome or return is known with 100% certainty. If the expected return is 10% or $100, you are fully guaranteed the result.
While it is debatable as to whether any investment can be termed risk-free, for investment purposes certain government short term debt issues are considered to be certain. In the United States, the 13 week US Treasury Bill (T-bill) is considered to be a risk-free investment at this time. Similar applies in Canada.
Why is knowing the risk-free rate of return important?
It is believed that investors are rational creatures. That means that all else equal, investors will choose the more efficient investment option when faced with two choices.
Efficiency, in this case, refers to the relationship between risk and return. When having a choice between two investments of identical risk, investors will always select the asset with the higher expected return. Alternatively, when choosing between two investments with identical expected returns, investors will choose the asset with the lesser risk.
While not always followed in practice, it should make sense.
For example, say 13 week US T-bills offer an effective, annual return of 10%. In essence, the risk-free rate is also 10%. That means you could invest in T-bills and be guaranteed a nominal annual return of exactly 10%.
Since all other investments have a higher level of risk, rational investors will never accept less than a 10% expected return for a risky investment.
The greater the risk, the higher the return demanded by the investor.
US government bonds are less risky than most corporate bonds. Therefore, if you look up yields on different bonds, you will see higher yields on corporate versus US government bonds with the same characteristics.
Similarly, riskier companies must pay higher interest rates than more secure companies.
This is the same as personal loans from your bank. If you are a valued client with lots of assets, you might get a loan at the prime interest rate. But if you have no track record of repayment or have had difficulties making debt payments in the past, you will need to pay higher rates than prime.
Use the risk-free rate of return as a minimum benchmark when considering investment options.
If the risk-free rate is 10% and you are contemplating an investment with an expected return of 6% and a standard deviation of 4%, you would never invest in the riskier asset as it offers less expected return.
But what about an asset with a 15% return and standard deviation of 10%? You might give pause. Yes, the potential return is higher than US T-bills, but the risk is significantly higher. In fact, 95% of the time, your actual return will be anywhere between 35% (good) and -5% (not so good).
Whether you think this is a better investment than the T-bills is based on your own risk tolerance. Risk tolerant investors may be enticed with the potential for up to 35% returns. Substantially more than the 10% guaranteed T-bill return. The risk averse may not want to chance losing up to 5%. For them, T-bills are a much preferable and safer investment.
There is no correct answer here. A lot is based on your risk tolerance, investment objectives, and personal constraints.
But by knowing the risk-free rate, you have additional information to make better decisions.
I will say though that I have no idea if an investment with an expected return of 15% and a standard deviation of 10% is good or bad. Like nominal returns, maybe it is or maybe it is not. I need more comparative data.
Relative Rate of Return
With the real and risk-free rates of return we considered investment options relative to inflation rates and guaranteed returns respectively. Those should be baseline benchmarks when assessing potential investments.
But you should also compare your investment returns to other benchmarks. These include: prior year results; analyst or company expectations; the market as a whole; the industry in which the asset lies; predetermined benchmarks.
In our example, the nominal return was 25%. A good return for an American with 3% inflation and a 10% risk-free return. But only relative to those two specific benchmarks.
In reality, I have no idea if it is good or bad return. I need more information.
Perhaps the investment in our example was Fantasy Bank shares.
I would be interested in how the shares performed over the previous years. If the 5 year average return was 40%, maybe 25% this year is relatively weak. Had you bought expecting a 40% return based on historic performance, you will not be happy with a mere 25% actual return.
What if I told you the general stock market grew 12% over the year and that the average banking industry shares rose 30%. You would be happy that your stock outperformed the general market return, but unhappy that you underperformed other banking stocks. On a relative basis, you would have been much wiser investing in a different bank.
In examining potential assets, you consider expected returns. For many investments, analysts and industry experts have expectations for the coming year. If analysts predicted that Fantasy would grow by 50%, you would be disappointed with 25%. Especially if you based your investment on a risk-return profile incorporating the 50% expected return.
You can set up a variety of other benchmarks to compare performance. But you should always compare your actual and expected returns relative to predetermined criteria.
That gives you a few thoughts as to why you should never consider investment returns in isolation.
Always compare your actual and expected returns agains relevant benchmarks.
Your decision-making and portfolio performance will benefit.
Next in our investment series, some further evidence that all returns are not the same.
by WWM | Jun 15, 2017 | Returns
Today we begin exploring the concept of investment returns. A relatively straightforward concept.
The return is the gain or loss you experience on an investment. Pretty easy compared to our risk analysis.
Or is it?
While the above definition applies, investment returns are slightly more complex.
There are a variety of return calculations. The importance of each depends on the individual investor’s personality and circumstances. We will look at three common return calculations today.
Total Return
Total Return equals:
(Sale Proceeds – Purchase Price + Net Cash Flows + Reinvestment Income)/Purchase Price
Sale proceeds and purchase price are self-explanatory.
Net cash flows include interest and dividend income. It may include interest expense on any debt used to finance the investment. And taxes payable on any gains or income incurred.
Transaction costs are sometimes factored into net cash flows. I prefer to add them to the purchase price and deduct them from the sale proceeds. Alternatively, you can track them separately as investment expenses should you so desire.
Reinvestment Income
Reinvestment income is the income you earn on income received. Incremental income earned on reinvested income is a key to compound returns.
For example, you purchase one share of ABC for $10. You receive a dividend of $1.00. You put that cash dividend receipt into your personal savings account and earn $0.10 in interest. You then sell the share for $12.
Total Return is the capital gain (sale proceeds minus purchase price), the dividend income (net cash flow), and the interest income earned from the cash dividend (reinvestment income). In this example, it is $3.10 or 31%.
When calculating, investors often forget to factor in the reinvestment income.
Contextualize Total Returns
31% sounds like an excellent return on ABC. But is it?
Total Return relates to the return over the entire period of time you owned the asset. One day, one year, one century.
Perhaps you bought and sold the stock in one week. Then the return might be impressive (or maybe not as we shall discuss later). But what if you bought the stock in 1970 and sold it in 2010? On an annual basis, 31% over 40 years may not be that attractive.
Or what if I offered you two investments. One provides a Total Return of 100%. The other, 10%. You would obviously be tempted by the first. However, if the holding period for option one is five years and only five weeks for option two, your decision might change.
That is a big problem when people speak of Total Returns. Without any context of time, it is hard to assess the relevance of total return as a performance measurement.
So when someone talks to you about returns, make sure you put it in a time context.
Annual Return
Annual return calculations are very common to equalize and compare performance.
A simple way to calculate Annual Return is to modify the Total Return calculation,
Annual Return equals:
(End Year Value – Start Year Value + Year’s Net Cash Flow + Year’s Reinvestment Income)/Start Year Value
This formula acts as if you bought the investment at the start of the fiscal year and sold it at year’s end.
In using this formula, you can quickly compare performance of different investments over the same time horizon.
Holding Period Return
You may also come across something called a Holding Period Return.
Holding Period Return equals:
(Ending Value/Beginning Value) – 1.
This is like the Total Return except it does not include net cash flows nor reinvested income.
If you invest in assets with significant cash flow aspects (e.g. bonds, preferred shares), you will be missing out on a material portion of actual return by ignoring cash flow and reinvested income.
But if you invest in common shares of small capitalized (“small cap”) growth stocks you likely will not receive any dividend income. In this case, Holding Period Return will equal Total Return.
You can calculate Holding Period Return for any combination of time periods. Just determine a beginning and end date and you are set.
A Lesson to Remember
There are other returns that you will see. We may consider a few more in due course.
If you learn the equations, or have a decent financial calculator, calculating investment returns is not difficult.
But always remember to compare apples to apples and oranges to oranges when calculating and analyzing returns.
Depending on the asset and conditions, different return calculations can yield materially different results.
Make certain that you use the correct ones to arrive at the best conclusions.
And if someone tells you the expected or historic returns are 15% (for example), make sure you know exactly which type of return they are using. This can be an issue with funds. Make sure the performance is net of expenses and fees and not gross returns.
With a variety of return options, you will usually be informed of the one that is most favourable to the person telling you. And that may not be in your best interest.
by WWM | Jun 7, 2017 | Diversification
Today we shall look at a few more areas of interest relating to diversification.
In An Introduction to Diversification, we saw that Investopedia recommends holding a “wide variety of investments” to benefit from diversification.
Further, that a diversified portfolio will generate “higher returns and pose a lower risk than any individual investment found within the portfolio”?
Is this true? What does it mean?
A Wide Variety of Investments?
The greater the number of investments in one’s portfolio, the greater the diversification.
This implies that you should have as many investments as possible in your portfolio.
However, the greater the number, the less the impact from any one additional investment.
If you have a single asset portfolio and add a second asset to the mix, there will be significant impact from the new asset. But if you have 1000 assets equally in your portfolio, the addition of one more will have minimal influence.
The “Ideal” Number of Investments
So what is the ideal number?
The optimal number of individual investments, excluding such things as funds, fluctuates slightly from study to study. Some claim that 20-30 proper investments will result in strong diversification. Other studies found that 15-20 stocks can provide adequate diversification to eliminate nonsystematic risk. Some studies even believe that the benefits of diversification are exhausted in portfolios with more than 15 investments.
As to what is the right number, I think it varies depending on the investor. If I got creative, I could probably build a portfolio of 10 or less assets that managed to diversify efficiently. Others might need 40 to properly diversify. It depends on one’s investment objectives, constraints, accumulated wealth, access to markets, economic conditions, etc., etc.
Asset Correlations are Key
The key to effective diversification is the correlation between the investments.
If you are comfortable investing in fine art within your investment portfolio, you may not require many assets to diversify. If you only want to invest in North American based public companies, you will require significantly more assets to diversify.
Regardless of the “right” number, you can see that it is not substantial. And by that, I mean less than 50 individual assets.
Less investments are also better for long term compounding. Buying and selling multiple investments results in transaction costs and potentially taxes payable on any gains. That negates the impact of compound returns.
Another factor to bear in mind is your opportunity cost (the cost of your time). Researching and monitoring 30-50 existing investments, plus potential assets, can require substantial time and energy. Unless your hobby is financial analysis (a fun hobby, I grant you), you probably do not want to spend your free time monitoring investments.
Higher Returns Through Diversification?
I have thought a bit more about the Investopedia statement. It is still inaccurate, but I think I can explain it.
I do not believe that you can get higher returns just by diversifying. As I explained previously, a portfolio’s expected return is simply the weighted average of every component’s expected return.
But diversification does allow the ability to add higher return assets to the portfolio to improve the overall expected return of the portfolio.
Say you have a two asset portfolio. Asset A has an expected return of 10.0% and a standard deviation of 5.0%. Investment B has a 14.0% expected return and a standard deviation of 8.0%. Your portfolio is 50% of each and the correlation between the two assets is 0.70.
Skipping the calculations, click here if you want to see the basic formulas, the portfolio has an expected return of 12.0% and a standard deviation of 6.0%. Note that we have already breached the Investopedia statement that a diversified portfolio will yield higher returns than any individual investments in the portfolio.
But we can get a nice increase in expected returns by adding a high risk investment to the mix. Let us add asset C with an expected return of 50.0%, but a standard deviation of 30.0%. Further the correlation between asset A is 0.60 and 0.90 with asset B.
The ABC portfolio will have an expected return of 24.6%, a huge increase from the 12.0% expected return of an AB portfolio. But again, the higher average is less than the return of asset C on its own.
So while you may be able to increase expected performance in a portfolio, it will never be greater than the return of all individual assets.
What about risk though?
Lower Risk Through Diversification?
As we saw with our correlation calculations, proper diversification will lower portfolio risk. Again, not necessarily lower than all individual assets though.
In our two asset AB portfolio, the standard deviation is 6.0%. Less than asset B’s 8.0% risk but more than asset A’s 5.0%.
Note that by combining two less than perfectly correlated assets, we reduce overall portfolio risk versus a weighted average calculation (in this case, 6.5%) as we calculated with expected return.
Now let us look at adding asset C to the risk calculation.
The standard deviation of ABC portfolio is 13.5%. Now the combined risk is higher than both A and B on their own and even the AB portfolio itself.
Like returns, Investopedia’s statement on lower risk is a tad faulty.
What Should Investopedia Have Stated?
I am not going to hammer Investopedia as they tend to do a good job. However, by keeping things brief and general, at times you do not get the optimal story. True with everyone, including me.
I might have looked at the impact of diversification on portfolio returns and risk.
For a given return level, proper diversification will reduce the portfolio risk.
Or for a given risk level, proper diversification will provide higher returns.
But that is for the portfolio as a whole, not compared to its individual investments.
Adding Assets to Reduce Portfolio Risk
For example, you have a single asset portfolio, asset X. Its expected return is 20.0% and its standard deviation is 10.0%. You like the return but are concerned about the amount of risk. You decide to add another asset in a 50% mix of the two assets and find two potential investments that both have 20.0% expected returns.
Investment Y has a standard deviation of 10.0%, the same as asset X. Asset Y has a 0.20 correlation to X.
Investment Z has a standard deviation of 7.0%, lower than X. Its correlation to X is 0.90.
An XY portfolio will have an expected return of 20.0%. But an XY standard deviation will only be 7.8%.
An XZ portfolio will also have an expected return of 20.0%. But the XZ standard deviation will be 8.3%.
Both portfolios are more efficient than holding asset X alone.
Note that XY is more efficient than XZ even though Y has a higher amount of risk than Z. That is because of the differences in correlations. The lower the inter-asset correlation, the greater the risk reduction impact.
The same may be said for someone wanting to enhance portfolio returns while keeping risk stable.
Adding Assets to Increase Portfolio Returns
You own asset X and are comfortable with portfolio risk of 10.0%. However, you would like to increase your potential returns. Perhaps you find investment option S with an expected return of 28.0%, a standard deviation of 13.0% and a correlation with X of 0.50.
In combining the two assets equally, the expected return of XS has increased to 24.0%, but the standard deviation remains the same at 10.0%.
Again, correlation plays a significant role in risk reduction. Had the correlations been 0.90 rather than 0.50, the standard deviation of XY would be 11.2%. For investment options with high correlations, you would need to accept lower risk-return profiles to equal the risk of X alone.
Okay, I hope that helps clarify diversification.
And I hope you can see how important asset correlations are in achieving proper portfolio diversification. It is so much less about the number of assets in your portfolio and so much more about the correlation between portfolio assets.
If not, do not worry. It is a rather complicated subject. I just want to lay the groundwork now for when we look at asset allocation and portfolio construction strategies.
I think we will move on to a discussion of investment returns next.
by WWM | Jun 1, 2017 | Diversification
Today we will look at an example of how asset correlations impact portfolio diversification.
Namely the impact on portfolio risk and expected returns.
Correlations in Action
Exxon Mobil is a multinational oil and gas publicly traded company. Let us pretend that your investment portfolio only holds shares in Exxon. A non-diversified portfolio.
The expected return of Exxon is 15% and the investment risk (i.e. standard deviation) is 10%.
You have read that diversifying your portfolio helps reduce portfolio risk. So you want to sell half your Exxon stock and invest the proceeds in another instrument.
From your research, you find two possible investment options.
Option one is shares of Chevron, another multinational oil and gas company. Option two is the Fine Art Fund; a mutual fund made up of fine art investments. Both have the same expected returns, 25%, and standard deviations, 20%.
If they both have the same risk-return profile, does it really matter which one you select?
Yes!
In many ways, Exxon and Chevron are the same company. They are in the same industries, operate in similar countries, and are affected by the changing price of oil and related commodities. One should expect their share prices to mirror each other to a great degree.
Their performance will not be exact due to company specific risks.
In 1989, faulty equipment, human error, and fatigued crew were factors in the crash of the Exxon Valdez in Alaska. A crash that caused many problems for Exxon.
In Ecuador (and other jurisdictions), Chevron is involved with the Ecuadorean government (and others) over environmental issues that may result in fines and costs to Chevron.
But for the most part though, in the absence of unique situations, the share prices of major oil companies generally move together up or down.
That is why I would anticipate the correlation between Exxon and Chevron being close to 1.0 (i.e. 100% positive). Not exactly 1.0, as the two companies operate in some different markets, have different product mixes, different management, etc.
I would expect over a long period for the two companies to track each other quite well in share price. Compare the five year performance between Exxon (stock symbol: XOM) and Chevron (stock symbol: CVX) – you can compare companies using Yahoo Finance Interactive Charts – and the similarities over time are striking.
But although they are close, they are not exact matches. That is good for diversification.
But not great.
The Importance of Correlations
Anytime the correlation between two assets is less than 1.0, there is an advantage in reducing overall risk by adding the new investment to one’s portfolio.
That is because of the portfolio risk-return calculations.
In (very) short, by adding assets that are not perfectly correlated to each other, one receives the cumulative impact of the expected returns, but only a reduced impact on portfolio risk.
I have re-read the Investopedia definition of diversification a few times.
I do not really understand what they mean when they state diversification will “yield higher returns and pose a lower risk than any individual investment found within the portfolio.”
I agree with the latter part of the statement, but have trouble with the first section.
Correlations and Portfolio Expected Return
While diversification allows you to invest in assets with high expected returns, diversification does not give the portfolio any magic bump.
In an investment portfolio, the expected return of the portfolio is simply the sum of each individual investments’ weighted averages in the portfolio.
For a simple, two asset portfolio:
ERp = (Wa)(ERa) + (Wb)(ERb)
Where:
ERp = Expected return of the portfolio
Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)
ERa = Expected return of investment “A” in the portfolio
In our example, the expected return of Exxon is 15% and 25% for Chevron. If you invest 50% of your portfolio in each asset, the portfolio’s expected return should be 20%.
ERp = .50(15) + .50(25) = 20%
Pretty easy.
Remember that expected returns are just weighted averages of all the individual investments.
Correlations between assets do not impact the expected returns of the portfolio.
Correlations and Portfolio Risk
However, it is not that simple a calculation for the risk of the portfolio.
You need to factor the assets’ correlations into the equation. In a two asset (A and B) portfolio:
℺²p = (W²a)(℺²a) + (W²b)(℺²b) + (2)(Wa)(Wb)(℺a)(℺b)(pab)
Where:
℺ = Standard deviation
Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)
pab = Correlation between investments “A” and “B”
The first part of the equation looks a lot like the expected return calculation. In that sense, there is a weighted average effect from risk.
But let us see how the second part of the equation alters the equation’s impact.
Diversification Impact of Strongly Correlated Assets
In our example, the standard deviation for Exxon was 10% and for Chevron 20%. Because the two companies are quite similar, I shall say that the correlation coefficient is 0.85. Not quite 1.0, but close.
If we crunch the numbers we see that the portfolio standard deviation is 14.49%. Slightly less than if we simply took the weighted average (15%) as we did with expected return.
The difference is due to the fact that the two assets are not perfectly correlated. However, because the correlation of 0.85 is very high, the reduction in risk is relatively small.
Diversification Impact of Weakly Correlated Assets
Now let’s consider our other potential investment; the Fine Art Fund. It had the same expected return (25%) and risk (20%) as Chevron. Therefore, we would expect an Exxon-Fine Art portfolio to yield the same expected return and risk as the Exxon-Chevron combination.
Actually, no we would not expect that in the slightest.
Here’s why.
In the real world, the correlation between fine art and oil companies is negligible. There is almost no correlation between the performance of Exxon and a bunch of paintings. Let us say the correlation between Exxon and the fund is 0.002.
Now for the numbers.
The expected return of a portfolio consisting of 50% Exxon and 50% Fine Art Fund would be 20%. The same as with the combined Exxon-Chevron portfolio.
This is because both Chevron and the Fine Art Fund have the same expected returns. And, as we saw above, expected return calculations are simply weighted averages of the portfolio’s individual investments.
But the portfolio risk is a different story.
If we crunch the numbers we see that the portfolio will have a risk of only 11.2%. Much less than a pure weighted average of 15% and significantly less than the Exxon-Chevron combination of 14.49%.
Yet the expected returns of both a portfolio of Exxon-Chevron or Exxon-Fine Art Fund are identical at 20%.
From a risk-return aspect, the Exxon-Fine Art Fund is the much better investment combination than Exxon-Chevron.
Why is Option Two Superior?
Because of the correlation between the assets.
Assets with high correlations receive some impact through diversification. But as you move toward a perfect correlation of 1.0, the risk reduction benefits from diversification lessen.
If you really want to reduce portfolio risk, you need to add assets that have low, or even negative, correlations to the assets already in the portfolio.
Investopedia states that diversification “mixes a wide variety of investments within a portfolio”.
True.
But to make it worthwhile, be certain you consider the correlations between assets as well as expected returns and risk levels in your investment selections. You want to add assets that are weakly correlated to your existing portfolio. Not simply a “wide variety of assets.”
The impact on your portfolio’s efficiency could be huge.
As for the optimal mix, there are many other variables that need consideration. We will look at them down the road in asset allocation and portfolio construction.
This sort of gets at the Investopedia claim about how diversification can “yield higher returns.” Say you find a weakly correlated asset that offers higher expected returns to add to your portfolio. You may be able to maintain your portfolio risk at its current level, yet get a bump by adding the potentially higher return asset. Poorly worded by Investopedia.
Next up, a few more thoughts on the benefits of diversification.
by WWM | May 24, 2017 | Diversification
In An Introduction to Diversification, we began our review of the subject.
Learning even a little about asset correlations is crucial to better understand why diversification is important in an investment portfolio.
Asset correlation is a relatively advanced topic. For some, that means I will not get into it as much as you would like. For others, your eyes may quickly glaze over in boredom.
Either way, I hope you gain some insight about correlation and how it can help you improve your investment results.
What is Asset Correlation?
Correlation is a statistical measure (no escaping the world of stats!) of how one asset moves in relation to a second asset.
With investment assets, risk factors can significantly affect performance. We looked at many of these variables in our discussions of nonsystematic and systematic risks. Government policies, inflation, interest rates, hurricanes, company management are a few examples.
The closer in characteristics two assets are, the more they will be affected by the same risk factors. The more divergent the assets, the less impact individual risk factors will have on each at the same time.
Let us use coffee shops to illustrate this point.
Two Starbucks franchises located on the same city block in New York are almost identical in nature. Same clients, same products, same impact from changes in coffee prices, and so on. There may be some minor differences, but not many.
If the city suffers an economic downturn, each shop should suffer equally. If Starbucks is investigated for selling coffee laced with carcinogens, business at both will fall.
Now compare a Starbucks with an Italian espresso shop on the same block.
Many of the same risk factors will be identical because of their physical proximity and product offering. If the local economy falters, both businesses may have difficulties. But if Starbucks is sued for potentially killing customers, Starbucks will suffer whereas there will be no negative impact on the espresso bar.
What about comparing two Starbucks? One in Los Angeles, one in Zurich.
Again, there are similarities between the two, but also large differences. If an earthquake in Los Angeles destroys every Starbucks in the city, there will be no problems for the Zurich franchise. If the Swiss economy struggles and customers look for more cost effective coffee options, that has no direct effect on business for a Starbucks in California.
We could look at many more combinations, but you get the idea.
Correlations and Investing
Like Starbucks’ franchises, some investments share many of the same traits and risk factors. Others have little in common. Some even react in opposite directions to the same risks.
How an investment moves or performs relative to another asset is its correlation.
And this correlation is the reason you want to hold a “wide variety of investments” (per Investopedia) in your portfolio.
When two investments are positively correlated, their performance will move in the same direction. Like two Starbucks on the same street.
When two investments are negatively correlated, if one asset outperforms its expected results, the other will underperform. Perhaps like a pawn shop on the same city street as the Starbucks.
When the economy is great, it’s frappuccinos for everyone. People are making money and not needing to hock their assets. The pawn shop is a lonely place.
But when bad times hit and people become unemployed, there is less money available for a premium priced coffee. Starbucks struggles and may incur losses. Meanwhile, the cobwebs have been cleared off the pawn shop cash register and business is booming. At least until the economy recovers and the Starbucks’ baristas are back at work.
If the movements of two assets are exactly identical, they are 100% positively correlated. If they move in exact opposite directions, they are 100% negatively correlated. If they have no relationship at all, the correlation is 0%.
In investing, correlations range from 1.00 (100% positive) to -1.00 (100% negative).
Most assets are positively correlated to varying degrees. In part this due to increasing globalization and far reaching risk factors that impact most assets. These include inflation, interest rates, government policies, and employment rates.
While most assets are positively correlated, few are perfectly correlated. That is, few assets have correlations of 1.0.
Consider the two Starbucks on the same street. As close in likeness as can be. However, one manager may be better than the other, resulting in customers buying more accessories. Or perhaps the baristas are better in the second shop. They are friendlier, faster, and serve better quality drinks. So although both shops have the same offering, customers over time may increasingly frequent the shop with better service.
Even in a small example like this, there are potential differences between almost identical businesses. This is equally true for investments. And, as we shall see below, these minor differences can play an important role in managing portfolio risk.
Correlations between two specific assets may change over time. As the characteristics and circumstances of the underlying investments shift, so too can the correlations.
Next up, a real life investment example of asset correlations in action.