In portfolio management, the term “correlation” has been mentioned many times as its very characteristic formed the basis of diversification among the asset classes. For those who are new to investing, correlation is “a statistical measure that determines how assets move in relation to each other”1. As the various asset classes behave differently during differing market and economic conditions, their relative price movements with one another would be different given a set period or snapshot of time.
However, there has been a notion that correlation in terms of price and returns is a zero-sum game. For example, in a portfolio consisting of two asset classes (let us call them A and B) and they are negatively correlated with each other, the assumption is that if the price of A rises, the price of B would drop, vice versa. Yes, that is correct, but only half; the correlation numbers are not fixed, and there are times where A and B gain together, and at times where both suffered losses together.
As stated above that correlation is a statistical measure, it is being defined by the time frame used. If in a day, the price of A and B moves in tandem, whether up or down, they are positively correlated with each other for that moment. However, if A and B moves differently from each other over a longer period, then their correlation may be less positive, or possibly even negative, for that said period.
Hence, it is not surprising to see A and B were having a negative correlation over set time, and yet both had positive returns. Providing a real-world example, I would use two asset classes that were conventionally opposites in the correlation thing, equities and gold (see Figure 1):
Asset Class | VTI | GLD | Annualised Return |
Equities (VTI) | 1.00 | -0.14 | 23.81% |
Gold (GLD) | -0.14 | 1.00 | 26.66% |
Fig. 1: Asset class correlations of equities (represented by Vanguard Total Stock Market ETF (VTI) and gold (represented by SPDR Gold Shares ETF (GLD), 1 Jan 2024 to 31 Dec 2024, using monthly returns correlation basis. Source: Portfolio Visualizer.
The Bedokian’s Take
While correlation forms part of the overall concept of diversification, for the retail investor, my take is to be aware of it and how it works. Leave the correlation numbers crunching to the academics, analysts and financial bloggers like me to provide useful insights for all.
Another trivia, which may come as a surprise to you, is that the main cause of correlation comes from you and me (sort of), and the rest of the participants in the financial markets. I will provide a couple of links under Related Posts below to understand why this is so.
Stay calm and stay invested.
Related posts:
Know This, And You Are Halfway Knowing How The Market Works
Diversification Is Dead! Long Live Diversification!
1 – Edwards, John. Why Market Correlation Matters. Investopedia. 31 Oct 2022. https://www.investopedia.com/articles/financial-advisors/022516/4-reasons-why-market-correlation-matters.asp#:~:text=Correlation%20is%20a%20statistical%20measure,in%20relation%20to%20each%20other (accessed 23 Feb 2025)
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