Correlation: A balancing tool
Joel Dresang: Kyle, when we talk about a diversified investment portfolio and trying to have a balance between reward and risk among various assets, one of the things that you use to measure that is correlation. Explain that for me.
Kyle Tetting: Sure. At its core, correlation really allows us to measure the relationship between different assets or different asset categories. It really gives us the ability to measure on a very fundamental level what one asset is expected to do relative to another.
Joel: What does this mean to investors?
Kyle: Really, the goal is to build a portfolio that has some assets that do different things, not just all assets that go up in one market environment, but some assets that go up, some assets that might go down, so that over time we’re participating in different ways in the economy and in the markets as a whole.
Joel: So, ideally, you want to have something that zigs when another thing zags…
Kyle: Yeah, absolutely. And it’s not just about two different asset categories or two different assets. It’s about all these different pieces working together. And that’s really where the benefit comes for investors and where we can add some value, is in picking these different things that kind of all work together, so that as some of them are moving one direction, others are moving the other.
So we can really reduce the risk of a portfolio without completely sacrificing returns. That really allows us to maximize the returns relative to the level of risk we’re taking.
Joel: How, how do you measure correlation?
Kyle: It looks at the historical relationship between two different asset categories. So if we’re talking about stocks and bonds, and we do look back and say, “Okay. Stocks have done this over time,” or “Over, you know, the last 30 years, they’ve done this. Bonds have done this.” And how do those two relate to each other?
Joel: So, is that ever a problem that you’re measuring things historically?
Kyle: It absolutely is a problem that we’re measuring things historically. And I think the major drawback we’re looking at is that historical performance isn’t an indicator of future performance. We can draw some pretty good relationships between what has happened and what we expect to happen.
Joel: Correlation works, except when it doesn’t?
Kyle: Yeah. Over the long run, the theory tends to hold true. We really want to look at what economic conditions are and what that means for correlation. But over the long run, yeah, we’re able to find places to reduce risk while still finding ways to add value.
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 April 28, 2014)
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Learn more Watch Kyle Tetting in Talking Money: Modern Portfolio Theory as well as in Talking Money: Measuring risk and reward Also, learn about the Efficient Frontier in balanced investing from Steve Giles