To foster financial literacy, our weekly podcasts regularly feature discussions on common terms and concepts used in personal finance and investing. Here’s an edited transcript of a conversation with Bob Landaas and Brian Kilb.

Bob: Correlation is the movement of asset prices relative to other asset prices. If an asset class has a high correlation with another asset class, they both move almost in lock step. One goes up, the other goes up. One goes down, the other goes down.

Analysts figured out that a really intelligent way to reduce the risk in your investment portfolio is to try to uncouple the asset classes from one another and have asset classes that have low correlation with one another. Then, if you get hurt in one area of your account, something should pop in another area of your account to balance off the risk.

Over the last 25 years, there has been a fairly low correlation between stocks and bonds. One goes up, the other goes down. We saw that recently with Treasury bonds having a significant rally when stocks lost ground.

Our firm has had a proud record of averaging returns of over 7% a year the last 10 years. And it’s not that we got clairvoyant 10 years ago in successfully predicting that bonds were going to make more than stocks. It had to do with correlation theory.

Brian: And just because you may have gone through a period – like the financial crisis of 2008 or August and September of 2011 – where the data doesn’t support the theory, it doesn’t mean that in the long run the theory isn’t going to be valid.

Everything doesn’t always work all the time. As people run away from risk, they’re going to run away from all the higher-risk categories. In periods like that, when all asset categories get walloped – except perhaps Treasuries and cash and gold – correlation theory doesn’t work every hour of every day of every financial period.

Bob: The goal here is risk reduction. Everybody needs to focus on reducing the risks in their accounts. The upside sort of takes care of itself. But you have to control the downside.

A key point is that correlation theory is heavily dependent on economic conditions. In the past, we’ve had low inflation and strong growth. In the future, they’re calling for gradually rising inflation and sluggish growth. Should that come to fruition, it’s going to force us to introduce other types of asset classes besides stocks and bonds – primarily as a risk-reduction technique.

We’re always trying to figure out how to reduce risk without sacrificing return. There are some things you can control in your portfolio. Correlation is one of them. And it’s a wonderful way to reduce the risk in your investments.

initially posted Nov. 11, 2011

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