Correlations and Investing

One of my favorite bloggers is Ben Carlson. He is a CFA (Chartered Financial Analyst) and author of the blog A Wealth of Common Sense. I would strongly recommend you check out his blog by clicking on the link here.

Mr. Carlson has had some great posts recently on correlations as it relates to investing. To preface, investors often look for lowly correlated, negatively correlated, or uncorrelated assets because this is a basic principle behind diversification, famously referred to as the only free lunch in investing. However, just because an asset has a low correlation or is uncorrelated with another does not make it a good investment. As Mr. Carlson writes, this is because correlations are dynamic, not static, meaning they change over time. Additionally, the risk-return tradeoff still must be considered when deciding between investment assets. For example, Mr. Carlson notes how "cash has little correlation with the S&P 500, just as commodities do, but that doesn’t mean it makes sense to hold cash over the long run." Furthermore, investing solely for the sake of negative correlation can be inappropriate as well:

The problem with a focus exclusively on correlation is that stocks are up on average three out of every four years. So there isn’t an investment that perfectly offsets the risk and returns from stocks with similar performance. Correlations also tend to change when high returning strategies are discovered by the wider investing community.

In other words, since stocks are up on average three out of every four years, assets negatively correlated with stocks must be down on average three out of every four years.

Another issue is that when everything goes extremely poorly (i.e. a depression or recession), the correlation concept fails. Mr. Carlson writes:

The other problem with diversification is that it can fail you at the worst possible times. We saw this in the 2008 crash when everything got killed, save for cash and U.S. Treasury bonds. When markets go terribly wrong, correlations tend to go to 1 (everything falls together). 

Overall, investing in assets solely because they provide negative correlation, low correlation, or are uncorrelated can be a dangerous strategy. That being said, diversification is an essential aspect of investing and correlation is a significant part of diversification. However, each assets must be considered from a risk-return standpoint both from a individual standpoint as well as from a comprehensive and holistic point of view.

- Joe

sources:
A Lesson in Portfolio Correlations via A Wealth of Common Sense
William Bernstein on Diversification via A Wealth of Common Sense
There’s No Such Thing As Precision When Investing via A Wealth of Common Sense