Setting up a correct portfolio of assets is almost as hard as being convinced to “invest” rather than “just spend”. It’s debatable if everyone knows the potential benefits of investing vs. the dark pit of spending and how the potential outweighs the risk.
Many investment firms (in the front line of educating people) are a long way from becoming proper advocates of the spend/invest association, but today, we will be looking into a different type of relationship. That of asset correlation and why its relevant when setting up an investment portfolio.
Correlations are not constant as they change in different environments. Depending on inflationary/deflationary pressures or high/low economic growth, what we know as normal is anything but normal. We look into all of them in our training sessions, but examples of such changes happen with stocks and bonds or stocks and crypto assets.
What is positive, negative and neutral correlation?
Positive – when two subjects move in the same direction.
Negative – when two subjects move in the opposite direction.
Neutral – when there is no correlation between the two subjects
A statistic is used to indicate the relationship from -1 to 1, with 1 indicating positive correlation. Any number closer to 0, is in limbo.
Why is asset correlation important?
Because a basic principle of a risk mitigated portfolio is diversification. According to the biggest asset managers, a portfolio is not diversified by investing in assets that perform the same during certain market conditions (positively correlated). It’s diversified by holding negatively correlated assets with proper allocation percentages. In a job well done, it will probably do better on a good day than lousy on a bad day, which is still proportionately positive and vice versa.
Other than holding negatively correlated assets, one also needs to account for predictability vs unpredictability. Think of insurance on your car. You pay a premium you might not need to exercise within the year but when required, it secures you from higher costs and painful bills. A portfolio is setup with a similar goal in mind. It will include assets that are expected to have a higher return but also assets that safeguard against downturns and unexpected moves. Knowing the current asset correlation can be valuable, especially if you’re prone to shock related heart conditions or passing out.
The most well-known strategy is the 60/40 portfolio allocation. 60% investment in stocks and a 40% investment in bonds. In times of economic expansion, stock markets are expected to produce higher returns and investors tend to prefer them more than fixed income (bonds). Bonds provide a cushion during economic contractions or recessionary environments due to their predictability and relative stability.
In different environments where inflationary or deflationary pressures are dominating, the correlations change. A build up of inflationary pressures like a pandemic or war (not your average cost-push or demand-pull inflation) is a good example of a positive correlation between bonds and stocks. Bonds rise first, then stocks tend to follow. The 10-year treasury is said to be a good indicator. Example of the 90s all the way to the Dot Com bubble at which point stocks and bonds parted ways (also known as decoupling, when deflationary pressures started building up. Investors were taking funds out of stocks and investing in bonds).
- Not all bonds are created equal. From junk bonds to investment grade and everything in between, there are risks to factor in before the purchase. Bond maturity also plays a role, since from a T-bill’s less-than-a-year duration, to a 30 year bond’s duration, a lot can happen in an economy within the 30 year unpredictable gap.
- An economic contraction doesn’t push investors completely out of stocks. It calls for a more defensive approach – hence the term defensive stocks like utilities/staples (two out of eleven sectors that categorize shock absorbing stocks), or even blue chip.
- Cash is king (or is it?). Another defensive approach (more like a sitting duck or a babe-in-the-woods) is cash. Does sitting on a bank account with inflation eating cash like a very hungry caterpillar, make for a strong defense?
Spring chicken vs old geezer.
Its increasingly reported that the crypto/stock markets are mostly uncorrelated. Especially when countries don’t kill each other, and masks are not covering our faces from virus-covered projectiles (too much??) Under healthier conditions of prosperity, the crypto world has its own Alfred to drive it around (even for the majority of 2021, during pandemic). All assets were pushed around by your average forces, while bitcoin was doing its own thing.
Fast forward to now, and a correlation of +0.6 indicates a strong positive relationship when things are anything but normal. It’s only a matter of time before the two markets become uncorrelated again but what does this mean for portfolio diversification using bitcoin? Right now, not so useful as you can imagine.
Correlations between indicators and assets – Example of interest rates and bond prices
During economic contractions, central banks lower interest rates to boost economic growth and make borrowing cheaper.
- When interest rates drop, the bond prices go up because they pay better interest (coupon) than the current rate and all newly issued bonds.
- The relationship is inverse (one down, one up). They are said to be negatively correlated
- Bond yields, are also negatively correlated to bond prices. The reason is that interest paid on bonds is fixed. The bond price though, is fluctuating.
- Dividing the fixed coupon with a higher bond price, will produce a lower yield
- Dividing the fixed coupon with a lower bond price, will produce a higher yield
- Both points above, stipulate a positive correlation between interest rates and bond yields.
Correlations like these are used frequently by analysts in their effort to get as close to making a correct choice, as many times as possible. Nothing is set in stone, reading the markets can be a hit-and-miss game.
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The information provided is strictly for informational use and is not meant in any way to be construed as investment advice. One should seek expert advice, as all investment strategies involve risk of loss.