• Editor

The Correlation Conversation

While fund performance and fees are commonly taken into consideration when discussing the construction of investment portfolios, there is one element that is probably not fully considered by the average investor. That element is correlation. While this is quite a complex concept that is clearly understood by investment professionals, there is a simplified version that is both useful and interesting for those of us not included in the CFA WhatsApp group. So, a very clear ‘health warning’ to said investment professionals – this is the marketing version of what correlation means.

What is Correlation?

Plainly speaking, correlation informs how likely it is that two variables will move together, e.g. how likely are infection rates to rise as the number of people vaccinated increases? Reasonably, one would assume that infection rates would fall as vaccination numbers rise, which would mean that they are negatively correlated.

Let’s unpack this concept further:

Positively correlated things tend to move together; a high correlation means that when one variable goes up, the other is very likely to go up as well.

(i.e. If bacon sales rise 10% and egg sales also rise 10%, they have a perfect positive correlation of 1)

Negatively correlated assets tend to move opposite of each other; when one variable goes up, the other variable usually goes down.

(i.e. If gumboots drop 10% and ice creams rise 10%, they have a perfect negative correlation of -1.)

A correlation of zero equates to statistical independence. If two variables are statistically independent, like chalk and cheese, it means that each has no bearing on the other.

(i.e. If one rises 10% and the other doesn’t move at all, they have no correlation.)

Why does this matter and what should an investor do with this information?

Anyone with a savings or investment plan will probably have catered for shorter and longer term events. You don’t want to have to liquidate your equity investment or tap into your retirement fund to cover the excess on an insurance claim and so you will probably have kept some money easily accessible in a bank account for just such an unexpected situation; it’s rational and practical.

Similarly, you don’t want your longer term investments all riding on the same bus. The most obvious reasons are twofold: if you want/need to access the funds and they are all in a slump together, you will turn notional/theoretical loss into actual loss if you cash in. If you diversify your funds so that they perform counter to each other, this risk is minimised. Secondly, the sleep well at night factor! While we all love the idea of a constant upward trajectory for our investment choices, we know that reality doesn’t really care what makes our dreams happy. So, again, by mitigating the risk in your portfolio by having uncorrelated investments, your panic attacks can be milder and your sleep more restful.