Can’t Stand the Market Heat? Cool It Down With Correlation

Recently, I wrote about how large annual market swings are more the norm than the exception. If you can stomach them, your money should grow over time. But, ugh, what a ride.

Instead of positioning your portfolio at either end of a wild see-saw, why not place it closer to the middle? You can do that by leveraging something called correlation. By building your portfolio with a mix of investments that don’t play so nicely together, you can tamp down some of its biggest swings.

What Is Correlation?

Correlation measures the probability that two investments will go up and down together. If two investments always moved up and down in lock step, they would be 100% positively correlated. If they always moved in exactly opposite directions, they would be 100% negatively correlated.

In reality, I’ve never seen investments with 100% positive or negative correlation. But there are some that come close. For example, S&P 500 stocks have an extremely high positive correlation with U.S. large-company growth stocks. If one moves up or down, the other one does too, by nearly the same amount.

You also can have 0% correlation. For example, over the last 5 years, U.S. small-company growth stocks had no correlation to corporate bonds; the movement of one was random in relation to the other.

Applying Correlation to Your Investment Portfolio

To reduce your portfolio’s volatility, hold a mixture of asset classes with no, low, or negative correlation to one another. For example, bonds and stocks often exhibit negative correlation. Interestingly (at least to me), real estate and commodities have had 0% correlation for the last 5 years. Mixing these sorts of assets together should result in less volatility for your whole portfolio than for its individual parts.

Achieving an optimal portfolio mix isn’t easy. It helps to have software, and the training to use it. But at least you’re now more familiar with the role correlation can play in your investing. By having a mix of stocks and bonds, and maybe real estate and commodities, you can reduce your portfolio’s volatility. And a less-volatile portfolio should be easier to stick with.

Written by John A. Frisch, CPA/PFS, CFP®, AIF®, PPC®