Should You Be Paying Attention to Non-Correlation?
Pretty much every investment out there boils down to one simple question: risk. After all, risk and reward are two sides of the same coin in investing, and you have to understand risk in order to make smart investments.
Here’s the catch: knowing the risk of an overall asset class doesn’t tell you much about the asset in particular. Nor does it tell you anything about the asset’s risk relative to the rest of your portfolio. But in order to keep your portfolio balanced at a risk level that works for your goals, you have to understand that relative risk.
The best way to do that is through non-correlation. Here’s a closer look at non-correlation and why you should be paying attention to it.
What are Correlation and Non-Correlation in Investing?
In investment, correlation is a statistic that measures the degree to which securities move in relation to each other. It’s typical for market movements to cause some asset classes to move in the same general direction, though there are plenty of assets that move in opposite directions—or have no correlation at all. The third option is known as non-correlation.
Correlation and non-correlation come in degrees. Broadly speaking, you can think of correlation and non-correlation as points along a pole. Positive correlation sits at one end, negative correlation sits at the other, and non-correlation sits right in the middle.
This is expressed as the correlation coefficient, a value that must fall between –1.0 and 1.0. Perfect positive correlation (when assets move in tandem) is expressed as 1.0, perfect negative correlation (when assets move in opposite directions) is expressed as –1.0, and non-correlation is expressed as 0.
Keep in mind that because most assets have complex relationships, you usually won’t see perfectly rounded correlation coefficients. However, it gives you a useful measurement spectrum. For example, if two assets were shown to have a –0.1 correlation, just below zero, they’re reasonably non-correlated with a slight tilt toward negative correlation.
What is a Non-Correlated Asset?
Non-correlated assets are two or more assets that do not correlate to each other. In other words, they move neither in tandem nor in opposition.
Non-correlated assets are also described in general relation to the market. For example, alternative investments are assets whose value is not generally tied to the stock market, making them non-correlated to the market. However, some specific alternative investments, like hedge funds, may have a closer relationship to the stock market compared to blue-chip art.
Correlation, Non-Correlation, and Modern Portfolio Theory
Modern portfolio theory, or MPT, is a popular method for risk-averse investors to construct diversified portfolios without surpassing their acceptable level of risk. And the foundation of the theory is non-correlation.
The concept is simple. Under MPT, investors can construct a diversified portfolio and boost overall returns by investing in assets that are not positively correlated. Because your assets don’t move in the same way at any given moment, you’ll always have a safety net if one asset allocation takes a hit. Conversely, it also means that your portfolio is always positioned for relative success in the market without the steep highs and lows of owning one asset type.
Your returns won’t be as high as your risk-hungry neighbor, but on the other hand, you’re more likely to generate stable returns in the long run.
MPT achieves this by using statistical measures, including correlation. In this theory, the individual asset’s performance is less important than how it fits into the overall portfolio. For example, if two assets are exactly the same except that one has high correlation with the rest of your portfolio and the other does not, MPT investors will opt for the second.
Why Non-Correlation Matters
Non-correlation (and correlation) express the strength of the relationship between two assets. This is expressed numerically as the correlation coefficient and must be between –1.0 and 1.0. The closer to 1.0, the more positive correlation. The closer to –1.0, the more negative correlation. But if you’re close to zero, the assets are non-correlated.
Regardless of whether you ascribe to MPT, non-correlation is essential to developing a diversified portfolio. The whole point of diversification is to insulate your portfolio against volatility in a single asset class, which can only be achieved with a good balance of non-correlated assets.
For example, if you invest heavily in stocks, your portfolio isn’t truly diversified unless you counterbalance it with assets that are not correlated to the stock market, regardless of the strength or diversity of the stocks. If you invest in the S&P 500 index, for example, you should also consider investing in non-correlated assets like art or real estate.
In fact, professional financial advisors rely primarily on non-correlation (in tandem with your risk tolerance) to develop a diversified portfolio.
However, it’s important to keep in mind that correlation and non-correlation were easier to calculate when MPT was first devised. Modern markets used to have less positive correlation overall. These days, the global economy and instant news cycle means the economy is quicker to respond to change than it once was. In other words, correlation can change, and it can change quickly. Because of this, it’s important to keep an eye on the markets and keep reevaluating correlation to rebalance your portfolio.
Your Partner in Smart Alternative Investing
Non-correlation is all about finding assets that will insulate your portfolio against volatility. And if you invest primarily in stocks, that means it’s time to branch off the beaten path and try your hand at alternative investments.
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