Correlation

Correlation helps us determine how "related" to one another two investments or two portfolios are. Understanding the correlation between assets in your portfolio can help ensure the right level of risk and and ensure the right level of exposure to desired markets and asset classes.

If you have a portfolio of assets that all move in the same direction and to the same general magnitude (e.g. all of the assets in the portfolio go up , and they all go up 10% together) the diversification benefit might not be as strong as you'd hoped. This correlation problem was particularly exaggerated in 2008 when most asset classes decreased in value and decreased significantly all at the same time.

To combat this, we look for assets that are not strongly correlated with each other or a benchmark we are trying to diversify from. Over some time periods, finding assets that aren't significantly and positively related to each other can be difficult. In many time periods the major asset classes are highly correlated with each other and offer little diversification benefit.

Just like we don't know ahead of time what the performance or risk of any asset or portfolio will be we don't know in advance what the correlation between two assets or two portfolios will be, which is why portfolio construction is not an exact science.

Many professionals use historical correlation information as a guide, but also combine that information with existing capital market expectations, diversification strategies, risk management strategies, risk and return analysis, independent research and professional judgement to build portfolios.