Mind correlation to control risk
Paige Radke: I am here today to talk to you about a lesser watched but very important measure of assets: Correlation. Correlation is a term that many of you may have heard before, whether in our offices, in a math class, or even on the news. But what you may not know is the importance of asset correlation in investments as a risk-control measure.
The standard definition of correlation is the measurement of the relationship between two or more assets, based on their price movements. So, if assets have high correlation, they’re going to move in lockstep with one another. One goes up, the other goes up. One goes down, the other goes down.
This relationship is typically expressed as a number between negative one and positive one, where the closer you are to zero, the more likely you are to have no relationship whatsoever.
Now, if that number gets closer to negative one, assets are said to have a high negative correlation. So, one goes up, the other one goes down.
Take, for example, an airline stock and an oil stock, particularly when the price of oil is decreasing. So, if you’re looking at that airline stock, the price of oil is one of their inputs. It’s one of their costs. So, if they’re selling flights for the same amount of money, the revenue is staying the same, but the costs are going down. You’re going to see an increase in earnings. And if you see an increase in earnings, you’d expect to see an increase in the stock price as well.
Now, on the flip side, if you look at that oil company, they’re the ones that are actually selling the oil. So, as the price of oil decreases, their revenues are going down, but their costs are staying the same. So, you’re going to see a decrease in their earnings. So here, the airline stock goes up, the oil stock goes down. That’s negative correlation.
Now, if that correlation measurement is closer to a positive one, that’s when you’re going to say the two assets have a high positive correlation. So, this is where you’re going to see them move in the same direction. One goes up, the other one goes up with it.
A great example of this, which we actually saw play out at the start of 2018, is the relationship between the FANG stocks. So, Facebook, Amazon, Netflix, Google, and really all other media, tech-based companies.
So, at the start of 2018, we saw Facebook get hit with some data privacy issues. They were selling our data, they didn’t have our permission, and because of that, Facebook stock went down. Now, that was something that was unique to Facebook. They were the ones that were selling our data. Yet at the same time, we saw that permeate across to all the other FANG stocks, so they went down with it. That’s because, even though it was something unique to Facebook, the implications – particularly of higher regulation – would also impact those other companies as well.
So, something happened. One goes down, the other ones go down with it.
Now, taking it back to low correlation or being closer to zero, you’re going to be really hard-pressed to find assets out there that have no relationship whatsoever. The only thing that you might see that in is cash, but nobody wants to hold only cash in their portfolio because then they’ll never see any growth.
So, that brings us to our next chart. This one here is called the correlation matrix. So, as I said, you’re going to be hard-pressed to find assets that have zero correlation, but what you can do is actually is look at different asset classes with different correlation levels.
So, what this one shows is the correlation relationship between different asset classes over the past 10 years. So, first I want to draw your attention to that first column under there for U.S. large-cap stocks. As you can see going down there, you see the correlation relationship amongst those different asset classes. International stocks have a higher positive correlation, and that’s to be expected over the last 10 years. We saw increased globalization. We saw synchronized global growth. So, you would expect to see that.
Now, going down that column, what I really want to draw your attention to is the relationship between the bonds and the large-cap U.S. stocks. It is a negative correlation, right? So, if you have stocks, they’re going to act in a different way than bonds. But what’s really important is looking across that row for bonds. You can see that they have a negative correlation with all other major asset classes. That is exactly the reason why correlation is so important in your portfolios.
We’ve all heard about the importance of diversification, right? Don’t put all your eggs in one basket. Don’t buy a bunch of stocks that are the same type. The reason behind why diversification works is those correlation relationships.
Modern portfolio theory says that investors can diversify away the risk of investment loss by reducing the correlation between returns of the securities within your portfolio.
So, think about that. If you have everything in your portfolio moving in the same direction all the time, you’re going to be in for a much more bumpy ride. Everything’s going to go up, everything’s going to go down. If you have assets within your portfolio that are moving in different directions, that increased volatility, those movements are going to level out. One thing goes up, one thing goes down. The net implications on your portfolio is going to be less movement.
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So, by constructing a portfolio that have different asset classes with low correlation, if you get hurt in one area of your account, there should be something else in your account that props that up and that ends up taking away the risk of selling things at the wrong time, because you have reduced volatility.
Now, of course, as with anything that’s in the economy and the markets, correlation relationships are not constant, and they’re heavily dependent on economic events. Take, for instance the financial crisis of 2008. At that time, we saw both the correlation between U.S. Treasurys and U.S. stocks, so stocks and bonds spiked. So, that’s something that was really nerve-racking.
Or, even more recently, at the start of 2018, we saw both your stocks and your bonds losing money at the same time. Like I said, that can be scary. That’s not the way your portfolio is supposed to work. Things are supposed to move in opposite directions.
But what you need to remember is that there’s multiple other times when we see this happen. It’s not a unique event.
For example, correlation has increased in all time periods of crisis and uncertainty. Think about it. It makes sense, right? If you have things in your portfolio and you’re uncertain about the future and there’s a crisis going on, you ‘re going to sell. You’re going to sell your stocks. You’re going to sell your bonds. You’re going to protect yourself. So, the correlation relationships increase because everybody’s selling and nobody’s buying.
On the flip side, correlation actually goes down when interest rates are higher. So think about this: If you have a stock that’s paying you 7%, and you have a bond that’s paying you 5%, you’re going to be more willing to look at those two as substitutes for one another. If you sell the stock, which has a little bit more risk, and buy this 5% bond, you’re really only giving away about 2% return but you’re going to be in for a smoother ride. So, you sell the stock, price goes down, buy the bond, price goes up. And that’s when you see that inverse relationship.
Whereas, if you have a stock that’s paying you 7%, and the bond’s only going to pay you 2%, you’re much less likely to look at those two as substitutes and be switching from one to the other. But just because we go through periods of time where the data doesn’t support the theory does not mean that in the long-run, the theory isn’t still valid.
Remember, the goal here is risk reduction. You need to have assets in your portfolio that react in different ways at different times. And I’m not just talking about stocks and bonds. That’s what I focused on here, but we have to look at it from stocks, bonds, U.S., international, developed markets, emerging markets, growth, value. Even the holdings within your portfolio that might react in different ways and have different objectives. Those are all ways that you can diversify by lowering your correlation.
So, in the long-run, the upside, that’s going to take care of itself. Your portfolio will go up in the long run. But what you need to do, and what we’re here to help you do, is make sure that your portfolio is controlled on the downside. And a really smart way to do that is by monitoring correlation amongst your asset classes.
Thank you very much.
(initially posted October 18, 2018)
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