Correlation: How investment balance can shift
Economic trends and other events can change relationships between investments, which is why, Kyle Tetting explains, investors need to monitor correlation. Kyle spoke with Joel Dresang in a Money Talk Video. The transcript follows.
Joel Dresang: Kyle, I want to talk with you about correlation, which is a key tool that you use in trying to balance a diversified portfolio. Let’s start with a definition first.
Kyle Tetting: Correlation is really the relationship between two different assets or even two different individual stocks or individual positions. It really explains the direction that the two move relative to each other.
Joel: So normally, stocks and bonds go like this (hands moving in opposite directions) but when you’ve got that correlation coming together, then they’re just going like that (hands moving in unison). And those relationships are based on long-term histories. But over the short-term, sometimes those can vary.
Kyle: Two great examples from the recent past – September 11, 2001 – when investors fled pretty much any risk category in favor of cash. Another great example – the debt ceiling crisis that we had in Washington. And the good news in those kinds of events is that, typically, as the fear subsides, things tend to normalize.
Joel: You mentioned some extraordinary conditions, what about economic conditions?
Kyle: I think the bigger issue for correlation is the long-term trend of the economy and kind of the prevailing interest rates and a couple of other factors, but one of the big things that we concern ourselves with are things like recessions.
Joel: What about now? We expect interest rates to stay low for a while and the economy to grow only at a slow pace.
Kyle: It’s certainly a unique environment from what we’ve seen that’s driven correlation up until now. What we’re seeing with bonds, in particular, the potential for rising rates, and stocks the potential for slow growth, as you said, we may see correlation tick higher now compared to what it’s been in the past.
Joel: So what does that mean for investors?
Kyle: It means we have to be much more careful about how we’re allocating our accounts, not just focusing on what historically has been true, but really keeping an eye on the way we’re allocating risk, knowing that – particularly now – bonds aren’t going to necessarily provide the cushion they used to provide when stocks turned south. What we can control is overall asset allocation. And one of the ways that we can diversify is to add not just stocks and bonds but a number of other categories.
Joel: So you can’t do much about correlation, but it’s something that you always monitor.
Kyle: It absolutely is something that we’re always monitoring. As economic conditions change, it’s really important to keep an eye on those relationships. And ultimately as correlations start to move closer to 1, as asset categories start to move alike, we need to be much more careful about how we monitor risk.
Kyle Tetting is director of research at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted June 20, 2014)
Landaas newsletter subscribers return to the newsletter via e-mail
More information For more on correlation, please click Correlation: A balancing tool (video) Talking Money: Modern Portfolio Theory (video) Talking Money: Measuring risk/reward (video) Building Your Portfolio, Using Diversification (Financial Industry Regulatory Authority)