Everything in the world is interrelated… or so we think. Non-correlated assets are assets that are differentiated in such a way that their value shifts differently than the broader market.
Investing in non-correlated assets is a way to diversify your portfolio, protecting yourself as an investor from loss as the market swings. Also called “zero” or “negative” correlation, totally non-correlated assets move such that as one goes up, the other goes down and vice versa.
If diversifying a portfolio is an investment strategy by which you put your eggs in different baskets, correlation is a measure that helps you to discern how different your baskets are, and where to put your eggs so that you don’t lose them all in one fell swoop.
Modern portfolio theory (MPT) is an investment strategy that describes how investors should seek to maximize their return based on the level of risk that they feel comfortable with. Correlation is a key measure in this theory of portfolio management, which accepts that increased risk is an inherent part of higher reward.
Investors can use this theory to optimize their return on investment by diversifying their portfolios to match their tolerance for risk. Investors can reduce risk in their portfolios by choosing non-correlated assets, which are scored from -1 to 1. (Two perfectly positively correlated assets would have a reading of +1, while two perfectly negatively correlated assets would have a reading of -1.)
While perfect positive or negative correlations are rare, where the correlation scores on the scale from -1 to +1 gives investors a sense of how differentiated assets are.
Investors can include non-correlated assets in their portfolios, thereby diversifying their portfolios in a few ways, including:
Correlation has changed following the financial crisis of 2008.
Until 2008, average absolute correlation was fairly stable with a few exceptions. Needless to say, things have changed.
Today, despite the fact that correlation can fluctuate, assets and asset classes are becoming increasingly correlated, especially when the market becomes more volatile. For example, international stocks and bonds once moved in the opposite direction of U.S. stocks and bonds, but they now impact one another more quickly than ever before.
Even though increased correlation has shown to dissipate again after a market crisis, because financial markets and economies are becoming more structurally integrated, investors may have more trouble diversifying their portfolios to protect against market downturns in the future.
Correlation is a measurement that helps the modern investor to frame his or her investment decisions. While you calculate correlation measures on your own, unless you are an experienced investor, you should seek outside the help of a financial advisor to establish correlation before putting your money down.