Correlation and Your Portfolio

What Is Correlation and How It Effects Your Portfolio

You just got on the freeway and are going 65 miles per hour. All of a sudden you hit some traffic. You’re now driving 10 miles per hour and you decide to change lanes. Whoops – bad move. The lane you change into slows down, and the lane you just left now goes faster.

So you decide to change back to your original lane and the same thing happens to you again. You’re really frustrated and mad at yourself because you just made 2 bad decisions.

Some people invest like they drive.

They buy a fast lane because it has done well in the past but then it slows down, and they either don’t make any money, or they lose money. What a major buzz kill. Bottom line, they are chasing performance. Is that you?

Investing doesn’t have to be such a struggle.

Investing doesn’t have to be about choosing one lane. You can have an investment in more than one lane. It’s called diversification. Some of the lanes I use with clients are stocks, bonds, real estate stocks, and commodities. Historically, they haven’t moved the same direction at the same time. Some have zigged while others have zagged. For example, stocks can go down, but real estate stocks and commodities can go up.

The degree to which 2 things move in the same direction is called correlation. Correlation ranges from 1.0 to -1.0. An example of a correlation of 1.0 is if stocks go up by 5% and bonds go up by 5%. A non-correlation is when stocks go up by 5% and bonds go down by 5%.

Big time point – right here!!! – You want things in your portfolio to zig and zag, and be non-correlated. The frustrating part is that correlations change.

For the last 5 years, commodities’ correlation to stocks has been 0.62. But for the last 3 years, the correlation of stocks and commodities has increased to 0.71. That means the degree to which these 2 lanes move the same way has increased. Remember, higher correlation means less diversification for your overall portfolio.

Part of the reason for the increase is because we now have a global economy and many countries’ economies are all tied together.

For example, let’s pretend that you own U.S. stocks and U.S. real estate stocks. Greece is in trouble. Think about the effect that Greece could have on U.S. real estate stocks. If Greece leaves the EU, their stock market could go down and so could the euro. If the euro goes lower, it could have an adverse effect on France, Spain, Italy, and Germany (other countries too) – causing those stock markets to go down.

The US economy is highly correlated to Europe’s economy. For example, Microsoft, Johnson & Johnson, Coca Cola, Cisco and many other U.S. companies get a substantial portion of their revenue from overseas. So if the US economy contracts because of the European economy, it effects the U.S. commercial and industrial real estate market. That could in turn cause U.S. real estate stocks to go lower.

What if you added another lane to your freeway portfolio?

Enter US Treasury bonds. The correlation of US Treasuries to US stocks (for the past 5 years) is -0.29. That means for the last 5 years, when US stocks have gown down, US Treasury bonds have gone up. So if you added US Treasury bonds to your portfolio of US stocks and US real estate stocks, you would be more diversified. Usually, the more diversified you are, the less risk you will take. Sweet!

Some of these lanes are inherently risky if you just choose that one lane. However, when you put the lane as a component of your overall freeway portfolio, it may reduce the overall risk of your portfolio and cut down your level of nausea!

Sometimes when you reduce the risk of your portfolio, your return can actually go up! That’s because you are adding non correlated assets to your portfolio. Yay!

Bottom line: build a freeway of non-correlated stuff. No more rear view mirror investing. Diversify your portfolio. That way you won’t have to feel like you have to pick the best lane. That’s just gambling.