Asset formula

What is Asset Correlation? | Definition and examples

Advertising disclosure
This article/post contains references to products or services of one or more of our advertisers or partners. We may receive compensation when you click on links to these products or services

When you start investing, it can be quite difficult to understand what your investments are and how they work, let alone how they interact with each other. But it is useful to understand the relationship between different investments and how they perform in relation to other assets.

Understanding asset correlation is especially important when working on creating a diversified portfolio. Read on to learn more about how asset correlation works, how it’s measured, and why it’s critical to building your investment portfolio.

What is Asset Correlation?

Asset correlation is a measure of how different investments perform relative to each other. Two assets that move simultaneously in the same direction are positively correlated, while those that move in opposite directions are negatively correlated. Some asset pairs have no correlation or relationship, which means they don’t tend to move with or against each other.

How to Measure Asset Correlation

Asset correlation is measured on a scale of -1.0 to +1.0. Not only does the scale measure whether two assets are correlated, but it also measures how closely related their movements are. The further an asset falls to one side of the scale, the stronger the positive or negative correlation.

For example, two assets with a correlation of +1.0 are perfectly correlated, meaning they always move in the same direction at roughly the same percentage. And if two assets are at -1.0, that means they are perfectly negatively correlated. They will always move in opposite directions by the same amount.

Finally, two assets with a correlation of 0 have no relationship. The movement of one of the assets does not necessarily mean that the other will move or predict which direction it will move if it does.

A mathematical equation is used to calculate the correlation between two or more assets. The most common formula uses the covariance and standard deviation of each asset. However, an easier way to measure it is to use an online asset correlation calculator. These calculators automatically calculate the correlation using the stock symbols of two stocks.

Asset Correlation Examples

To give you a better understanding of asset correlation, let’s discuss some examples of asset pairs that have positive correlations, negative correlations, and no correlation at all.

Positive correlation

As we mentioned, a positive correlation between two assets means that they are moving in the same direction at the same time. And the more closely correlated they are, the more similar their movements.

For example, if a stock gains 5% and is perfectly correlated to another stock, that other stock would also gain 5%.

Assets in the same sector are likely to have a high positive correlation since they are affected by similar market factors. For example, two automakers in the United States would likely have a high positive correlation.

Negative correlation

When assets are negatively correlated, they tend to move in opposite directions. Assets that are more strongly negatively correlated will be farther apart. For example, if two assets have a perfect negative correlation, when one gains 5% in the market, the other loses 5%.

In our positive asset correlation example, we looked at the stock prices of two companies in the same industry. To find examples of negative correlation, it makes more sense to look at two totally different assets: Shares and obligations.

When stock prices rise, investors tend to move away from bonds and into stock Exchange. But when the stock market is down, investors tend to turn to bonds. Due to their negative correlation, investment experts recommend having both stocks and bonds in your portfolio. This allows you to hedge your risk no matter how the market moves.

Zero correlation

When two assets have zero correlation, it means that they have no relationship with each other. In these cases, it is impossible to predict the movements of one asset based on the movement of the other.

In reality, it is difficult to find assets with zero correlation. The effects of the overall market tend to affect other markets. However, some assets may be less likely to correlate with the overall market. These assets may include immovable, merchandiseart, and more.

Cash is another asset that rarely correlates with others. That’s why many experts recommend keeping a portion of your portfolio in cash at all times in addition to investments that may correlate with each other.

Asset Correlation and Modern Portfolio Theory

Modern Portfolio Theory is a common investment strategy that seeks the perfect balance between portfolio risk and return. This theory is based on the premise that the market is generally efficient and that it does not make sense for investors to predict future investment returns or choose individual stocks. Instead, modern portfolio theory emphasizes the importance of diversification to minimize portfolio risk.

Asset correlation and modern portfolio theory are closely related. In fact, modern portfolio theory is entirely based on the premise that different investments have different relationships with each other.

When you follow modern portfolio theory, you include some assets that are positively correlated, some that are negatively correlated, and some that have no correlation. That way, no matter what happens with the market, you’ll have investments in your portfolio that are performing well (as well as those that are performing poorly.

Modern portfolio theory and asset correlation are useful tools for creating a well-diversified portfolio that can outlast any market, but it’s not perfect science. When we talk about perfectly positively and negatively correlated assets, we can assume that these assets will always have the same relationship. But that’s just not the case.

Today’s market is particularly unpredictable, so the correlation between different assets can change. That’s not to say you shouldn’t keep asset correlation in mind when building your portfolio. Remember that the correlation between two assets is not fixed.

Does asset correlation matter?

Understanding how asset correlation works is an important step when building your investment portfolio, especially when it comes to market ups and downs.

Again, an important example of asset correlation is the relationship between stocks and bonds. Most investment experts recommend including both asset classes in your portfolio. In fact, there are formulas for determining what percentage of your portfolio should be allocated to bonds. Some experts recommend a 90/10 stock to bond ratio. Others recommend subtracting your age from 120 and allocating that percentage of your portfolio to stocks.

As an investor, you will realize how important asset correlation is when you experience your first market correction. It’s easy to panic when you see your stock market investments lose value. But due to what is often a negative correlation, you may notice that your bond investments are doing well.

It is also important to note that correlation does not always equal causation. Some assets may tend to move in the same direction. But this does not mean that the movement of one of the assets leads to the movement of the other. It is more likely that similar factors caused the two assets to move. On the other hand, when two assets are negatively correlated, the positive movement of one does not necessarily cause the negative movement of the other (although it can).

The downside of asset correlation

The downside of relying on asset correlation when building your investment portfolio is that, as mentioned, the relationship between two assets can change. Assets that once had a negative correlation may eventually have a positive correlation, and vice versa.

Understand that there are no guarantees. And you are even more likely to see changes in the correlation between two assets in volatile and unpredictable markets.

It is also difficult to predict how new assets will play a role in asset correlation. For example, cryptocurrency has become popular even in times when the stock market is doing well. However, its performance has been volatile. And the jury is still out on whether and how it correlates to other assets.

Conclusion

Asset correlation describes the relationship between two investments. This is an important concept to understand when building a portfolio, as it can help you choose your investments to strike the right balance between risk and reward.


Source link