Asset Correlation – Definition, Examples, Problems, and Why It Is Important
Definition of Asset Correlation
Asset correlation is a measurement of the relationship between two or more assets and their dependency. This makes it an important part of asset allocation because the goal is to combine assets with a low correlation.
The correlation measurement is expressed as a number between +1 and -1. A zero correlation indicates there is no relationship between the assets. A +1 indicates an absolute positive correlation (they always move together in the same direction). A -1 indicates an absolute negative correlation (they always move together in opposite directions of each other).
Asset Correlation Examples
When two or more assets move up and down together. Stocks in the same industry would have a high positive correlation. They would probably be affected similarly by events.
When two or more assets show no relationship to each other. Combining multiple assets with no correlation would be an ideal diversified portfolio because volatility (risk) of the whole portfolio would theoretically be minimized. In the real world most assets have some correlation; so a low asset correlation such as between gold and S&P stocks, would be a good example of near non-correlated assets.
When two or more investments move inversely to each other they have negative correlation. Two assets that were perfectly negatively correlated would eliminate risk of the combined assets.
Perfect negative correlation is mostly only found in synthetic instruments such as futures contracts or inverse ETFs. These instruments can provide near perfect negative correlation and therefore can be useful tools to reduce portfolio volatility. Of course these instruments, particularly futures contracts, can be very risky if not employed properly.
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