Understanding Asset Correlation for Portfolio Diversification
The modern portfolio theory (MPT) encourages traders to select assets to maximise their overall returns within their accepted risk level. It emphasises the need to diversify the portfolio using statistical correlation among assets rather than choosing them randomly. Harry Markowitz, the pioneer of the theory, argued that a well-diversified portfolio must include a mix of high-risk: high-return and low-risk: low-return assets. Here’s a look at asset correlation that can be used to build a balanced portfolio.
Correlation Coefficients
The strength of the relationship between two assets is reflected by their correlation coefficient. The goal is to identify assets that have either:
- Low correlation - not impacted by the same factors or event.
Or
- High negative correlation or high inverse correlation - move in opposite directions in response to an event.
Traders pick a mix of assets with low and negative correlation to ensure maximum portfolio diversification. In such a portfolio, even if an economic data release or news event causes one set of assets to decline, the rest of the assets will either not respond at all or rise in response to the event. It helps traders hedge against the risks associated with any one instrument and cap potential losses.
To build a well-diversified portfolio, it’s also important for traders to have some knowledge of how macroeconomic and other factors impact various assets.
Calculating the Correlation of Two Assets
Experienced traders tend to calculate the correlation coefficient over longer durations. This is because including rising, declining, and ranging markets improves the accuracy.
Formula for calculating the correlation coefficient (R):
Traders should know their risk appetite and trading goals to create a portfolio that works for them. The correlation efficient is used to evaluate the variance in earnings based on different asset mixes. A low variance means lower risk and more benefits of portfolio diversification. However, this also means lower potential profits. The aim is to find the right balance.
There are easy-to-use correlation calculators that can be give insights about which assets to include in the portfolio. These calculators can be used to check the portfolio variance and ensure it lies within the risk tolerance limits.
The Correlation Scale
Correlation ranges between +1 and -1. Perfect correlation is expressed as 1, implying that the assets always move in the same direction to the same extent. When one gains 10% in value, the other will do so too. A perfectly negative correlation is denoted by -1. It means that when one gains 10% in value, the other will decline by 10%.
Here's a table to understand how various correlation values are interpreted:
Correlation Value |
Interpretation |
-1 |
Perfect negative correlation |
-0.99 to -0.75 |
High negative correlation |
-0.75 to - 0.50 |
Medium negative correlation |
-0.50 to -0.25 |
Low negative correlation |
-0.25 to 0.25 |
No correlation |
0.25 to 0.50 |
Low positive correlation |
0.50 to 0.75 |
Medium positive correlation |
0.75 to 0.99 |
High positive correlation |
1 |
Perfect positive correlation |
Limitations of Correlation
Markowitz's theory, though useful, has often been criticised for the underlying assumption that asset correlation will always be predictive and remain fixed. Since the relationship between assets may change with time, it very important to periodically reassess the correlation among assets in a portfolio.
Another aspect to finetune a portfolio is that reducing risks impacts the portfolio’s profit potential as well. The idea is to limit risks within a trader’s tolerance limits, rather than to eliminate risks.
Traders must also remember that the aim of portfolio diversification is not to enhance the profit potential, but to find the right balance. The main objective of portfolio diversification is to protect the portfolio from sudden, unexpected or unprecedented market movements.
Understanding the Correlation Among Popular Asset Classes
Here are some asset correlations most popularly used by traders:
- Prices of crude oil and other refined oil products move together. An increase in the supply of crude exerts downward pressure on gasoline and diesel. And an increase in the demand for refined products drives crude prices higher.
- Crude oil is quoted in US dollars, which is why these two assets share a negative or inverse correlation. When the US dollar appreciates, oil becomes more expensive for holders of other currencies and experiences a decline in demand, which exerts pressure on crude prices.
- Oil has a positive correlation with currencies of countries that export it. For instance, any increase in crude prices tends to lift the Canadian dollar, as oil is among the country’s largest exports.
- Commodities share a positive correlation with the currencies of countries producing and selling them. For instance, the Australian dollar is called a “commodity currency” due to its high positive correlation.
- Precious metals, especially gold, are considered safe havens. These are uncorrelated assets that are used by experienced traders to hedge against economic downturns.
- The S&P 500 has exhibited a strong correlation with popular cryptocurrencies. This is because both are supported by improvements in investor risk appetite.
- The Nasdaq 100, S&P 500, and DJIA tend to have a positive correlation.
- Although European and American indices have a positive correlation, this is not a very strong one, due to their distinct fundamentals.
Correlation Among Currencies
Even within the forex market, it’s possible to identify currencies to achieve portfolio diversification. It may seem that trading two pairs with a common currency in the opposite direction would cancel each other out. For instance, trading CAD/USD and USD/JPY. When the US dollar rises, a trader with both pairs will make losses on CAD/USD and gains on USD/JPY, but these losses and gains will not cancel each other out. This is because these two currency pairs do not have perfect negative correlation.
It's possible to identify pairs that have historically exhibited a strong inverse correlation, like the USD/CHF and EUR/USD, to diversify a forex-heavy portfolio.
To Sum Up
- A well-diversified portfolio can be created by using the correlation coefficient between different asset classes.
- A correlation coefficient is a number between -1 and 1, which reflects the strength of the relationship between two assets.
- A positive correlation means the prices of both assets move in the same direction, while a negative correlation means they move in the opposite direction.
- Assets with more negative correlation or no correlation provide higher portfolio diversification benefits.
- It’s important to regularly reassess the correlation among the chosen assets to maintain low portfolio variance.
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