Non-correlation of investment assets may seem to be complicated, but it is very important to the long-term success of an investment portfolio. To understand non-correlation, we must first understand what we mean when assets are correlated. Investment assets are referred to as being highly correlated when they show a tendency to vary together. For example, U.S. stock classes--large, medium and small-- tend to increase and decrease in value together. For many years, large international stocks were not considered to be correlated to U.S. stocks, but they are now 92% correlated. Bonds are not correlated to stocks. Bond groups--investment grade corporate bonds, U.S. Treasury bonds and municipal bonds--tend to be highly correlated. Stocks and bonds are not correlated and therefore each moves in its own manner. The importance of including non-correlated assets in your investment portfolio is to reduce investment risk. Bonds, stocks, real estate, emerging market investments, and commodities are non-correlated. By mixing these various non-correlated asset classes, your portfolio is not as likely to be whipsawed, up or down, by the volatility of one particular class of assets. While this strategy is helpful in most instances, it is not foolproof. On the other hand, including asset classes that are non-correlated doesn’t prevent them all, or most, from moving up or down at the same time. In 2008, we saw an example of non-correlated assets all moving down together, as the U.S. and world economies went through a terrible economic period. This is the exception and not the norm, but illustrates what can happen. For this reason, I believe that a static portfolio, one that sets an allocation of non-correlated assets that does not change, can be detrimental to your investment wealth. Depending on the state of the economy and other relevant information, raising or lowering the percentages of various non-correlated assets can be useful, and is an active asset management style.
Monday, January 13, 2014 at 12:49 PM