Why market relevance is important

Correlation is a statistical indicator used to determine the relationship between assets. It can be used for individual securities, such as stocks, or it can measure general market correlations, such as how the relationship between asset classes or broad markets changes.

Correlation is measured in the range of -1 to +1. The perfect positive correlation between the two assets reads +1. A perfect negative correlation reading is -1. Perfect positive or negative correlations are rare.

Key points

  • Correlation is a statistical indicator used to determine the relationship between assets.
  • Correlation is measured from -1 (completely negative) to +1 (completely positive), although a complete negative or positive correlation between two assets is rare.
  • Correlation can be used to understand the overall nature of a larger market or to measure the degree of diversification of assets in an investment portfolio.
  • Choosing low-correlation assets can help reduce the risk of the investment portfolio.

As a measure of market relevance

Correlation can be used to understand the overall nature of the larger market. For example, as early as 2011, the various sectors in the Standard & Poor’s 500 Index showed a correlation of 95%, breaking the historical record set in 1987. High correlation means that they all move basically in sync.

During this period, it is difficult to pick out the stocks that outperform the market. It is also difficult to choose stocks from different industries to increase the diversification of the investment portfolio. Investors have to consider other types of assets to help manage their portfolio risk. On the other hand, high market correlation means that investors only need to use simple index funds to gain market exposure instead of trying to pick individual stocks.

The relevance of portfolio management

Correlation is commonly used in portfolio management to measure the degree of diversification between the assets contained in the portfolio. Modern portfolio theory (MPT) uses a measure of the correlation of all assets in a portfolio to help determine the most effective frontier. This concept helps to optimize the expected return for a certain level of risk. Including assets that are less correlated with each other helps reduce the overall risk of the investment portfolio.

Nevertheless, the relevance will change over time. It can only be measured by history. Two assets that were highly correlated in the past may become unrelated and start to move separately. This is a disadvantage of MPT; it assumes a stable correlation between assets.

Correlation and volatility

During periods of increased volatility, such as the 2008 financial crisis, stocks may have a tendency to become more relevant, even if they belong to different industries. During periods of instability, international markets may also become highly correlated. Investors may wish to include assets that are less relevant to the stock market into their investment portfolios to help manage risk.

Unfortunately, during periods of high volatility, the correlation between different asset classes and different markets sometimes increases. For example, in January 2016, the correlation between the S&P 500 index and crude oil prices was very high, as high as 0.97, the largest correlation in 26 years. The stock market is very concerned about the continued volatility of oil prices. As oil prices fall, the market is beginning to worry that some energy companies will default on debt or eventually have to declare bankruptcy.

Bottom line

Choosing low-correlation assets can help reduce the risk of the investment portfolio. For example, the most common way to achieve diversification in a stock portfolio is to include bonds, because the two have historically been less correlated. Investors also often use commodities such as precious metals to increase diversification; gold and silver are regarded as common hedging tools for stocks.

Finally, investing in frontier markets (countries whose economies are even less developed and accessible than emerging markets) through exchange-traded funds (ETFs) is a good way to diversify the US equity portfolio. For example, the iShares MSCI Frontier 100 ETF, which is composed of the 100 largest stocks from the global small market, has a market correlation of only 0.54 with the S&P 500 index from 2012 to 2018, indicating its value as a company against large-cap U.S. stocks.

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