Consider Correlation to Diversify

Chart of the Week for February 24-March 2, 2006

Correlation measures the extent to which the returns of two asset classes are related. A correlation of 1.0 (perfect positive correlation) means that the asset classes move in perfect tandem; when one has a positive return, so does the other, in the same magnitude. A correlation of -1.0 (perfect negative correlation) means that when one asset class has a negative return, the other has a positive return, essentially the absolute value of the negative return. In theory, an investor would want to hold a portfolio of assets that are negatively correlated to reduce the risk of loss. Sadly, asset classes with perfect negative correlation only exist in theory. Still, investors can reduce risk by selecting asset classes that are less than perfectly correlated.

An interesting aspect of correlations is that they change over time, as the chart above illustrates. Although patterns of stock and bond returns have become more similar in the past few months, the current rolling 12-month correlation is well below the 20-year average of +0.23. Note, however, that because stock/bond correlation is never a perfect 1.0, there is clearly a diversification benefit to holding each in a portfolio.

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