At its most basic level, correlation is a statistical measure of how two securities move in relation to each other. Managing correlation and its effects on risk and return is a key feature in advanced portfolio management. Mathematically correlation is measured between -1 and +1. Securities with a correlation of +1 are 100% correlated, meaning they move in exactly the same direction, at the same time, at the same velocity. Securities with a correlation of -1 are perfectly inversely correlated meaning that they move in exactly the opposite direction, at the same time, at the same velocity. If the correlation is 0, the movements of the securities are said to have no correlation; their behavior is completely random.
We are always looking for a degree of non-correlated investments or non-correlation in portfolio construction to help us mitigate a variety of risks. If all of our investment choices across a family’s portfolio of assets are highly correlated, then all their assets are susceptible to the exact same risks. And high levels of correlation can create chaos in markets and in personal portfolios. Consider the market downturn of 2009. This market downturn had arguably one of the highest correlation across markets in modern history. Because of this, there was no safe haven for assets to hide from the storm. Everything went down together.
Managing correlation can be a powerful tool for designing portfolios that capture more of the upside of market opportunity and less of the inherent downside risk.
To examine correlation and its accompanying risks in your portfolio, contact a Trilogy Advisor.