Relationships. We all have them – positive ones, negative ones, random ones. Guess what else can have a relationship? Stocks, bonds, commodities, and more! We call the relationship between two assets investment correlation.
To be concise, investment correlation is the relationship between the average of two assets. Assets can have positive correlation, negative correlation or no correlation. Correlation can be measured between different types of securities, such as bonds, commodities and stocks, but can also be measured for the same type of security, for example between two different stocks. But why is correlation important to understand? You might have guessed by now, correlation is an important factor to diversifying your portfolio.
How is correlation calculated?
Let’s get technical. The correlation coefficient is the calculation for investment correlation. To find the correlation coefficient, take the standard deviation of asset X multiplied by the standard deviation of asset Y, and divide the covariance of both assets by that number. You can use the correlation coefficient to identify a correlation between two assets, specifically, if they are positively correlated, negatively correlated or uncorrelated.
What does positive correlation mean?
Positive correlation happens when the performance of two assets move with each other. Have you ever thrown two tennis balls in the air at the same time? When doing so, they both fall at the same time. That means that they are positively correlated.
When two assets are completely correlated with each other, they have a correlation of 1.0. Typically, you’ll see references to assets that have high correlation with a number just under 1.0.
An example of two assets that have positive correlation are Uber Technologies (UBER) and Lyft Inc (LYFT) between 1 January 2020 and 1 September 2020. Both companies are technology companies focusing on ride sharing. If you compare both their stock performance for 2020, both have had similar performances throughout the year thus far.
What does negative correlation mean?
Negative correlation happens when the performance of two assets move against each other.
Think back to your childhood days playing on a playground. Have you ever been on a see-saw? When one side goes up, the other side goes down. This is negative correlation.
If two assets are completely negatively correlated, they have a correlation of -1.0. Typically, you’ll see references to assets that have negative correlation with a number just above -1.0.
An example of two assets that have negative correlation are U.S. Oil Fund (USO) and U.S. Global Jets ETF (JETS). Let’s take their performance during the past three months as an example, between 1 June 2020 to 1 September 2020. It’s evident in the charts that these two assets are negatively correlated.
What does no investment correlation mean?
When two assets have no investment correlation, it is when their correlation is close to 0. Have you ever watched the way that a small litter of puppies run around in random directions? This is a great example of something having no correlation.
As much as we all love puppies, a (more relevant) example of two assets that have no correlation are SPDR Gold Shares (GLD) and Moderna, Inc. (MRNA) between 1 August 2020 and 1 September 2020. SPDR Gold Shares tracks the performance of gold, and Moderna, Inc. is a biotechnology company, most notably developing a vaccine candidate for COVID-19. In the graphs below you will see that they don’t have much of a correlation to each other during this time frame, therefore they are uncorrelated.
What does investment correlation mean for diversification?
Correlation is important when thinking about your portfolio and how to diversify stocks. Some assets do well and some do poorly during the same macroeconomic factors. Let’s take the current COVID pandemic as an example. We have seen tech stocks soaring, while airline stocks have dropped.
The modern portfolio theory argues that by reducing the correlation between assets within a portfolio, investors can diversify and reduce their risk.
Finding uncorrelated assets can help you manage risk to ensure you have the right mix of securities so that your portfolio is less susceptible to substantial moves in the market.
Keep in mind that correlation of certain securities can change, especially within different time periods. January of 2019 compared to January of 2020 for the same two assets may be completely different. But, if two assets have been correlated over a long period of time, you can probably guess that they’ll continue to be relatively correlated for the near future, if there are no major macroeconomic factors affecting each.