Correlation

Over the past few weeks we have discussed some of the key building blocks for the construction of a portfolio.

We identified standard deviation as a measure of risk or volatility. The higher the standard deviation of a security (or a portfolio of securities), the greater the risk.

We came up with several methods to measure risk. We can use the simple mean (or average), the time-weighted return (also known as geometric return), and the money-weighted return. When evaluating investment or fund managers, we use the time-weighted return, because it allows us to most appropriately evaluate performance in light of flows into and out of a portfolio or fund over an extended period of time during which performance may vary.

Last week I introduced Beta which is the measure of the risk of a security (or a portfolio of securities) in comparison to the market overall. We learned a common proxy for the market is the Standard & Poor’s 500 index. The convention in portfolio theory is that the market has a beta of 1. A security with a beta greater than 1 will have price movements that are greater than the market. A security with a beta less than the market will have price movements that are less than the market.

We’re still missing a critical piece of information. That is the way in which securities (or asset classes) perform in relation to each other. This is called “correlation.” We’re looking for securities that will provide diversification. If some of the securities in the portfolio are “zigging,” we want others to be “zagging.”

We can calculate this relationship between securities with correlation coefficient. The formula is a bit involved. So, I won’t post it here.

Correlation is measured from -1 to +1. Securities that have a correlation of -1 are perfectly negatively correlated. If one moves up by 10%, the other will move down by exactly 10%. Securities that have a correlation of +1 are perfectly positively correlated. If one moves up by 10%, the other moves up by exactly 10%. Securities that have a correlation of 0 have no relationship with each other.

In reality most securities are positively correlated with each other. Intelligent Investors are interested in building a portfolio that will be well-allocated across asset classes. The less correlated the asset classes in the portfolio the lower the risk. You can Google “asset class correlation” and find all kinds of data on asset class correlation.

I’ll have more to say about correlation in future posts.