Correlation is a statistical measure that determines how assets move in relation to each other. It can be used for individual stocks or assets, or it can measure how broader markets move in relation to each other. It is measured on a scale of -1 to +1. A perfect positive correlation between two assets has a reading of +1. A perfect negative correlation has a reading of -1. Perfect positive or negative correlations are rare.

During periods of heightened volatility, stocks can have a tendency to become more correlated, even if they are in different sectors. International markets can also become highly correlated during times of instability. Investors may want to include in their portfolios assets that have low correlations with the stock markets to help manage their portfolio risk.

Correlation As a Measure of Market Regimes

Correlation can be used to gain perspective on the overall nature of the larger market. For example, various sectors in the S&P 500 exhibited a 95% degree of correlation during 2011, which shows that they all moved basically in lockstep with each other. It was very difficult to pick stocks that outperformed the broader market during that period. It was also hard to select stocks in different sectors to increase the diversification of a portfolio. Investors had to look at other asset types to help manage their portfolio risk. On the other hand, the high correlation meant that investors only needed to use simple index funds to gain exposure to the market, rather than attempting to pick individual stocks.

Correlation for Portfolio Management

Correlation is often used in portfolio management to measure the amount of diversification among the assets contained in a portfolio. Modern portfolio theory (MPT) uses a measure of the correlation of all the assets in a portfolio to help determine the most efficient frontier. This concept helps to optimize expected return against a certain level of risk. Including assets that have a low correlation to each other helps to reduce the amount of overall risk for a portfolio.

Still, correlation can change over time. It can only be measured historically. Two assets that have had a high degree of correlation in the past can become uncorrelated and begin to move separately. This is one shortcoming of MPT; it assumes stable correlations among assets.

Correlation Tends to Increase During Volatility

Correlation tends to increase among various asset classes and different markets during periods of high volatility. For example, during January 2016, there was a high degree of correlation between the S&P 500 and the price of crude oil, reaching as high as 0.97. This was the highest degree of correlation in 26 years.

The stock market was very concerned with the continuing volatility of prices for oil. As the price of oil dropped, the market became nervous that some energy companies would default on their debt or have to ultimately declare bankruptcy. During the 2008 financial crisis, different asset classes became more correlated.

Choosing Assets With Low Correlation

Choosing assets with low correlation with each other can help to reduce the risk of a portfolio. The most common way to diversify stocks is to include bonds in a portfolio. Stocks and bonds have historically had a lower degree of correlation with each other. Investors also often use commodities such as precious metals to increase portfolio diversification.

To avoid excessive correlation, some investors use exchange-traded funds (ETFs) that track markets other than those in developed nations. The iShares MSCI Frontier 100 ETF had a correlation of 0.53 with the S&P 500 between 2011 and 2016. The ETF provides exposure to 100 of the largest stocks from frontier markets. Including exposure to frontier markets in a portfolio can help increase diversification and manage risk.

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