Diversification and Asset Correlations

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.