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Asset patterns resuming

Dollar Signs

By Marc Amateis

When discussing risk as it relates to an investment portfolio, we are usually referring to volatility. That is, how big are the ups and downs?

And when it comes to controlling volatility, there is no more important concept than asset correlation.

Asset correlation describes how different investments move relative to one another. Correlation can be between asset classes (stocks versus bonds) or between members of an asset class (growth stocks versus value stocks).

If two investments typically move in the same direction over time, they are said to be positively correlated. If they tend to move in different directions, they are negatively correlated, and if they move independently of each other they are uncorrelated. In addition, there are varying degrees of correlation, either positive or negative.

Imagine an investment portfolio comprised of just two investments, each one very volatile on its own, but perfectly negatively correlated to the other. That means they always move in the opposite direction. Put them together in a portfolio and what happens? When one goes up, the other will go down. So now you have created a low-volatility or low-risk portfolio out of two very risky investments.

More information:
For an earlier Talking Money feature on correlation, please click here.

Please click here for an article from the Financial Industry Regulatory Authority, on building portfolios using asset allocation.

The holy grail of investing is constructing a portfolio such that you increase performance while at the same time reducing risk. Diversification among asset classes and sectors helps get us there, but it takes more than just spreading our money around. It also requires understanding the concept of correlation and using it to our advantage.

At Landaas & Company, we build portfolios that take advantage of the different correlations between asset classes in order to reduce risk. The problem comes when outside forces cause normal correlation relationships to change. We see this most often during times of geopolitical turmoil, economic crisis and natural or man-made disasters. But we also see it during times of great investor euphoria.

During the 2008 bear market and financial crisis, fear caused investors to sell almost everything regardless of fundamentals (a condition known as “risk off”).  That resulted in falling values, even among investments that normally move in opposite directions. Then, when investors came out of their shells, they started buying everything (“risk on”), and most investments went up. This risk-on/risk-off dynamic can cause even well-diversified portfolios to swing much more wildly than normal. That makes it difficult to reduce risk through the use of historical relationships between investments.

Lately, correlation patterns have normalized. Asset classes that historically move in the same direction, opposite direction or independently are largely doing so. That means it is easier to construct a portfolio that will have investments that are going up even when others are going down. It also means that good actively managed stock funds have an advantage over passive index funds.

Think about it this way: If all stocks are going up or down together regardless of fundamentals, it doesn’t matter so much where you put your money.  Whether you own large or small company stock, domestic or foreign companies, they’re all going to go in the same direction. However, when investors are scrutinizing valuations and driving up prices of those stocks that are deserving, you want a good fund manager and not a computer making those stock picks.

As investors, we know we must accept market volatility. We also know there will be times, hopefully short-lived, when historical correlation patterns don’t hold. But most of the time, understanding asset correlation and using it as a tool in portfolio construction will improve performance while at the same time reducing risk.

Marc Amateis is a vice president and investment advisor at Landaas & Company.

(initially posted Oct. 21, 2013)

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