Introduction
Connected and unconnected assets are indicators of how investments move relative to each other. When assets move in the same direction at the same time, they are considered positively correlated. When one asset rises while the other falls, the two assets are considered negatively correlated. Assets that show no relationship to each other are considered uncorrelated.
Measuring Asset Correlation
A correlation value of 0 indicates that asset returns are completely uncorrelated. If there are two assets deemed uncorrelated, the price movement of one asset does not affect the price movement of the other asset.
Asset Correlation and Modern Portfolio Theory
According to what is known as Modern Portfolio Theory, you can reduce overall risk in an investment portfolio and increase your overall returns by investing in groups of assets that are not correlated. In other words, you can own assets that do not tend to move in the same way at the same time.
Correlation Can Change
The theory of correlation and uncorrelation is well understood, but it was easier to prove when investments were generally less uncorrelated. Modern markets are unpredictable and unstable, constantly changing in the ways they move.
How to Obtain Uncorrelated Assets
Diversifying the portfolio is one way to get closer to achieving uncorrelation. The reality is that true uncorrelation is rare these days, and financial experts work full-time trying to find the most efficient uncorrelated portfolio possible.
For most of us, owning a mix of stocks, bonds, and alternative assets like cash and real estate over the long term will be the way. These assets all tend to move in an uncorrelated manner and can help reduce the overall volatility of the portfolio. It is also known that gold is uncorrelated with stocks.
Does Diversification Make Sense?
Although investments have become more correlated, smart diversification can still reduce risk and increase your portfolio returns. Assets still tend to perform differently, and gains in assets still mitigate losses in other assets. By finding a mix of investments that suit your risk tolerance and long-term investment goals, you will have a very modern portfolio.
How to Research Correlation
There are many different tools and resources available to help you research the correlation of asset classes using popular ETFs and asset class indices. Generally, the less correlation or more conflict among asset classes, the more beneficial diversification will be in holding those classes in the investment portfolio.
Frequently Asked Questions
What is the correlation of risk-free assets? A risk-free asset has a largely stable value, meaning its price is unlikely to move significantly up or down at any time. Thus, its correlation with other assets will equal zero. When another asset rises, risk-free assets will mostly remain the same in the short term. When another asset falls, risk-free assets will mostly remain the same in the short term.
What is the purpose of analyzing asset correlation? Understanding the correlation of any assets you own can help you diversify your portfolio and reduce volatility. For active traders, understanding asset correlation can also help target trades and develop strategies. For example, when an asset shows an upward trend, you may want to target bullish trades with correlated impact or bearish trades in negatively correlated assets.
Source:
https://www.thebalancemoney.com/what-is-asset-correlation-2894312
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