Correlation is a statistical measure that determines how assets move in relation to each other. It can be used for individual securities, like stocks, or it can measure general market correlation, such as how asset classes or broad 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.
Correlation As a Measure of Markets
Correlation can be used to gain perspective on the overall nature of the larger market. For example, back in 2011, various sectors in the S&P 500 exhibited a 95% degree of correlation, which means 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 types of assets to help manage their portfolio risk. On the other hand, the high market 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 returns 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 and Volatility
During periods of heightened volatility, such as the 2008 financial crisis, 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 assets in their portfolios that have a low market correlation with the stock markets to help manage their risk.
Unfortunately, correlation sometimes increases 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 – the greatest 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.
The Bottom Line
Choosing assets with low correlation with each other can help to reduce the risk of a portfolio. For example, the most common way to diversify in a portfolio of stocks is to include bonds, as the two have historically had a lower degree of correlation with each other. Investors also often use commodities such as precious metals to increase diversification; gold and silver are seen as common hedges to equities. Finally, investing in frontier markets (countries whose economies are even less developed and accessible than those of emerging markets) via exchange-traded funds (ETFs) can be a good way to diversify a U.S. equities-based portfolio. For example, the iShares MSCI Frontier 100 ETF, made up of 100 of the largest stocks from small global markets, had a market correlation of only 0.54 with the S&P 500 between 2012 and 2018, indicating its worth as a counterbalance to big cap American companies.