What is Correlation and Why Should You Care?
Think of correlation like a moving walkway at an airport. Go with me on this ...
Justin Davis
January 9th, 2023
Blog | What is Correlation and Why Should You Care?
tl;dr
Correlation tells you how often the price of assets move in the same direction at the same time.
Positive correlation = they tend to move in the same direction
Negative correlation = they tend to move in opposite directions
Combining less-correlated assets gives you better protection against market downturns and better long-term returns.
Ever used one of these walkways at an airport?
If so, you’ll remember what it felt like. Your normal walking pace ramps up immediately, letting you cover more distance in the same amount of time.
You’re walking twice as fas, or more, with no additional effort.
This is because your energy is combined with the energy of the moving sidewalk, effectively combining the efforts of both to produce a bigger change.
Which is great, because that’s what they’re built for: accelerating your speed.
But what if you walk in the other direction?
Now, instead of adding your own energy to the equation, you’re subtracting.
You’re suddenly cutting your own pace in half by running counter to the opposing force underneath your feet.
This, essentially, is correlation.
When two things move together at the same time, in the same direction, they magnify the impact.
And when two (or more) assets in your portfolio move together at the same time, in the same direction, they also magnify the impact. Sometimes good. Sometimes bad.
Correlation in your portfolio
Your portfolio is just a set of assets. Stocks, bonds, crypto, real estate - whatever.
The prices of those assets change moment by moment and day by day. You’ll often see the terms “price movement” or “price action” used to describe that change.
Since you have several of these assets all changing prices at the same time, there’s a chance that some of these prices change in the same direction, at the same time. And, like we saw in our airport physics lesson above, two things that move in the same direction at the same time multiply their impacts.
Practically, here’s what it means to your portfolio returns.
If you have two investments that tend to move up and down together, they’ll cause your portfolio to move up and down more than if they moved independently of each other.
Something that moves up and down more is more volatile, and we know that more volatile portfolios ultimately earn less than less volatile ones.
Your goal as an investor is to reduce your volatility as much as you can, while still keeping your returns about where you want them. And while you can’t predict your future returns, you can work to reduce your volatility immediately.
How to use correlation to build a more diversified portfolio
If correlated assets (again, those that move together) increase volatility, which increases risk, then it follows that the more uncorrelated your assets, the more you can reduce volatility and risk.
And this is something you can use next time you’re making a change to your portfolio!
Each time you decide to add more to your portfolio, or sell something, thinking about how that affects correlation in your portfolio gives you a way to evaluate and manage your risk proactively.
Given a set of ideas you have that you want to invest in that are equal in all other measures, you want the one that’s the least-most correlated with your portfolio. This is what “diversification” is all about - building a portfolio with a range of uncorrelated assets, so that they work together to reduce your overall risk.
Determining Your Portfolio Correlation
Figuring out the correlation between assets in your portfolio can be a daunting task. While the math isn’t hard, it can be seriously tedious.
We’ve written an article that outlines how you can calculate correlation between assets, which should give you a head start on getting to the bottom of how diversified your portfolio is today and we’ve built a calculator to help you see how correlated your assets are, and how much volatility and risk reduction you’re getting through diversification.
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