What Are Non-Correlated Assets?
Investment decisions often come down to the question of risk vs reward. While individual risk tolerances can differ, a diversified investment portfolio is still the most common strategy to minimize the potential for loss.
One of the easiest ways to do this is by looking at the correlation between different assets and deciding on an asset allocation that includes negative or zero correlation.
About Asset Correlation
Asset correlation is a statistical measure of how investments move relative to one another. This measure ranges from -1 to +1, where -1 indicates perfect negative correlation and +1 indicates perfect positive correlation.
In investment terms, when assets move in the same direction at the same time, they’re considered to have a positive correlation. When two assets move in opposite directions, they’re considered to have a negative correlation.
Assets that move without any relationship to each other, or have a correlation of 0, are considered non-correlated assets.
Measuring Asset Correlation
A correlation of 0 means that the returns of assets are completely uncorrelated. If two assets are considered to be non-correlated, the price movement of one asset has no effect on the price movement of the other asset.
Many different tools and resources are available to help you research asset class correlation using popular ETFs and asset class benchmarks.
This doesn’t necessarily speak to whether an asset will generate returns or not. However, the lower or more negatively correlated certain asset classes are to each other, the more diversification benefit of having those asset classes in an investment portfolio.
Correlation and Modern Portfolio Theory
Under what’s known as modern portfolio theory, investors can reduce overall risk in an investment portfolio and potentially even boost overall returns by investing in asset combinations that are not correlated or have low correlation.
If there is a correlation of zero, then there is no correlation and one asset’s direction may not signify another asset’s movement. If there is negative correlation, one asset will tend to appreciate while the other declines, and vice versa.
By owning assets with a range of correlations to each other, investors can maintain relative success in the market without worrying about the volatility of owning just one asset class.
When one asset class is performing well, your returns may not be as high as someone invested totally in that asset, but your losses also won’t be as extreme if that same asset starts to experience a downturn.
Benefits of Non-Correlated Assets
There are a variety of reasons why non-correlated assets are recommended by modern portfolio theory.
A diversified portfolio refers to one with a balance of asset classes, asset types, and correlation coefficients.
Why do investors want a diversified portfolio? Because different asset classes face different risks from different variables. When you spread assets across different asset classes, there is less likelihood that a decline in one asset will impact your entire portfolio.
At a high level, a portfolio that balances traditional assets with alternative investments that aren’t correlated with the stock market may not experience a downturn or losses to the same degree as non-diversified portfolios.
You’ll be the holder of a more balanced portfolio by finding a mix of investments that suits your risk tolerance and long-term investment goals.
Risks Associated with Non-Correlated Assets
Like any investment product, there are risks associated with non-correlated investments.
Some non-correlated investments are more complex and don’t have a marketplace where they’re easily bought and sold. Without an open marketplace, investors may find it hard to quickly sell the asset for a good price.
Another thing that impacts liquidity for non-correlated assets is their uniqueness. Some alternative assets are one-of-a-kind, such as Contemporary Art or NFTs. This means there’s less liquidity in the overall market than in public equities where each share is identical.
Asset Classes Not Correlated With the Stock Market
Below are some of the most common non-correlated assets, but there are countless other options depending on your investment strategy.
Gold traditionally has less than a 0.5 correlation coefficient with the stock market. Interestingly, the value of gold tends to correlate more with a growing market, while correlating less with a contracting financial market.
Because of its low correlation to the U.S. stock market, gold has long been considered a safe haven asset to hedge against the impact of market fluctuations.
People will always need somewhere to live. That coupled with the long-term nature of leases and mortgages make the value of real estate assets less reactive to economic news than traditional assets.
Better yet, you don’t even have to purchase physical real estate to get in on this alternative asset class. Real estate investment trusts (REITs) have low correlation with the S&P 500 — not too far off from gold at approximately 0.6. Plus, these assets historically perform better in the face of inflation.
Contemporary Art & Collectibles
Modern investors don’t always consider the physical things they own as part of their portfolio. But if they have value, and there’s the potential for that value to grow, things like artwork, antiques, homes, jewelry, vehicles and even your dad’s old baseball card collection are all assets.
Physical collectibles typically have their own niche financial markets where their value is set and where they can be bought and sold, making them non-correlated assets with value that is independent of the stock market.
Contemporary Art has consistently offered negative or zero correlation compared to the S&P 500 to traditional equities and indices, according to data from Citi Private Bank.
- Read more: Understanding Fractional Art Investing
At this point, every active investor has heard of cryptocurrency and NFTs. But there are also many more types (like, thousands) of digital assets — their market capitalization totals in the hundreds of billions, in fact.
Digital assets can include mobile apps, domains, websites, SaaS platforms, DeFi assets, social media profiles, and tons more.
These types of assets create a world of possibilities for investors who want to get creative with their diversification and really explore their risk/reward boundaries.
Emerging Market Securities
Emerging markets have a slightly higher correlation to the S&P 500 than previously mentioned asset classes, but still tend to provide diversification — not only through low correlation but also geographic diversification.
Correlation Can Change
The modern stock market is not as predictable or stable as it has been in the past. Emerging variables such as new asset classes and new classes of investors add a new layer of complexity to these theories of correlation.
Alternative asset classes, especially hedge funds and private equity, have a less consistent correlation because their returns depend on unique variables like the goals of portfolio managers.
In general, correlations will remain relatively stable but can vary by a few percentage points due to market conditions, interest rates, and investor sentiment. For example, correlations tend to be slightly different in bear markets than in bull markets.
The Bottom Line
Over the long term, asset correlation tends to be more diverse than when looking at correlation during shorter market conditions. Depending on the investment decisions you are making, the asset correlation you want to look for in your overall portfolio will differ.
As with every investment opportunity, it’s also important to remember that past performance does not guarantee future results. This is the same for correlation. Just because two asset classes have moved the same way in the past, it doesn’t guarantee they will always move in the same way.
If you are considering investing in non-correlated assets in order to help diversify your portfolio, doing some financial planning with an investment advisor may be helpful.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision