Diversification of your investment portfolio has long been considered a positive way to ensure overall growth in your investments. But there are parts of diversification that may not be immediately apparent, including the correlation of assets.
Seeking assets that are not correlated helps you diversify safely. You mitigate your risk and raise your chances of financial growth by finding investments that will not affect one another. But it’s a tough concept to fully understand.
What Is Asset Correlation?
Asset correlation refers to the relationship between growth and decline of two or more of the assets in your portfolio. Investments are often connected in some way – for example, an investment in a technology company’s stock may be related to an investment in the stock of a retail company who carries the technology company’s successful product.
Investors often use a percentage scale to measure how deeply related investments are to one another. The scale moves from -100% to 100% for each asset. At zero, two assets are uncorrelated; that is, they have no historical relationship in growth or decline. When one grows or declines, the other one remains unaffected.
- A positive percentage indicates that two stocks have a direct relationship. A 40% correlation means that when one of your assets has increased in value, the other has increased alongside it 40% of the time.
- Conversely, a negative percentage means that two or more stocks have an inverse relationship. A -60% correlation means that when one of your assets has increased in value, the other has decreased 60% of the time.
Keep in mind that a non-negative percentage measurement doesn’t mean that the relationship is only positive. The direct relationship means that two stocks may historically decrease together, as well.
Why Should I Avoid Asset Correlation?
Whether the relationships (and percentage measurement) of two or more stocks is positive or negative, correlation almost always translates to risk. Even if two stocks have been positively related in the past, that increases the chance that you’ll suffer twice the losses if one stock moves down (because the other is likely to move down with it).
Basically, both a direct and inverse relationship mean you’re taking on a greater risk. In an inverse relationship, or one in which one stock moves down when another moves up, you’re lowering your chances of making a profit.
Correlation is also subject to change. Markets can become volatile, and global ecommerce and improving methods of selling and shipping mean that business, as it always has, continues to increase in speed. Faster business means faster changes, and fast changes mean new relationships are forming among stocks all the time.
How Do I Find Non-Correlating Assets?
Diversify your investments to keep correlation low. Pour resources into a variety of investments, such as stocks, bonds, cash, and real estate. Research correlations using tools such as the Portfolio Visualizer or the Invesco Correlation Analyzer.
If you’re feeling overwhelmed, you can always talk to a financial expert at Americans For Life. Keep your financial goals in mind and consider correlation on a scale commensurate with the size of your investments.