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Tutorial |
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| Asset
Correlation |
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| Goal |
To explain the concept of asset
correlation, and to show why it is important to understand the implications of
correlation when considering assets for possible inclusion in your portfolio.
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| Definition |
Asset correlation measures the
extent to which the returns on two assets move together (i.e the extent to which
those returns behave similarly in response to market events or
stimuli).
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| How it
works |
Asset correlation
ranges from a maximum of +1.00 to a minimum of -1.00. If two assets have a
perfect positive correlation (+1.00), their returns will tend to move
simultaneously in the same direction. With a perfect negative correlation
(-1.00), their returns will tend to move simultaneously in opposite
directions. A correlation of 0 indicates that there is no relationship at
all between the price movements of two assets.
Since few asset pairs will come anywhere close to
perfect positive or negative correlation, the following rules of thumb can be
helpful:
- High Correlation: Asset correlation greater
than 0.75; implies that the two assets respond very similarly to the market
and that their prices will very often move in the same direction.
- Moderate Correlation: Asset correlation
between 0.25 and 0.75; implies that the two assets respond in somewhat similar
ways to the market and that their prices will move more or less in the same
direction, depending on how strong the correlation.
- Low Correlation: Asset correlation between
0.00 and 0.25; implies that the two assets respond fairly independently to the
market and that their prices also tend to move independently of one another.
- Negative Correlation: Asset correlation below
0.00; implies that the two assets respond fairly differently to the market and
that their prices will tend to move in opposite directions.
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| A Practical
Example |
An individual investor maintains a portfolio that includes shares of the
following assets: Intel (INTC), AT&T (T), Walmart (WMT), Vanguard
Wellington Income Fund (VWELX), Janus Fund (JANSX), and Vanguard Total
International Stock Index Fund (VGTSX). The matrix below shows how those
assets correlate to one another:
| Correlation |
INTC |
T |
WMT |
VWELX |
JANSX |
VGTSX |
| INTC |
1.00 |
0.53 |
0.21 |
0.35 |
0.42 |
0.25 |
| T |
0.53 |
1.00 |
0.29 |
0.27 |
0.42 |
0.12 |
| WMT |
0.21 |
0.29 |
1.00 |
0.24 |
0.31 |
0.12 |
| VWELX |
0.35 |
0.27 |
0.24 |
1.00 |
-0.08 |
0.84 |
| JANSX |
0.42 |
0.42 |
0.31 |
-0.08 |
1.00 |
0.72 |
| VGTSX |
0.25 |
0.12 |
0.12 |
0.84 |
0.72 |
1.00 |
In viewing this matrix, we can make the following
observations:
To illustrate the extent to which one asset can behave
differently from other assets, the Vanguard Wellington Income Fund serves as a
good example: This fund has moderate or low/moderate correlation with the Intel,
AT&T and Walmart stocks, a negative correlation with the Janus Fund, and a
high correlation with the Vanguard Total International Stock Index
Fund.
While not precise, it is generally true that the closer
your median or average correlation is to +1.00, the less diversified your
portfolio is likely to be.
In this portfolio, VGTSX's high correlations with VWELX and
JANSX suggest that this fund may be contributing less to portfolio
diversification than the investor thinks.
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| Conclusion |
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Correlation is important because it
serves as a checking mechanism on portfolio diversification. This is true
because portfolio diversification depends upon both the number and weightings of
portfolio assets, as well as their relative correlations to one another.
By including low-correlation asset pairs in your portfolio, you can "hedge" the
risk of otherwise volatile assets, diversify, and possibly lower your
portfolio's overall volatility.
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| Relevant Links |
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