Some things go together, like peanut butter and toast, tea and crumpets, soup and breadsticks. That’s fine for the table. But in your portfolio you don’t always want perfect harmony – sometimes you need salt in your coffee to avoid trouble.
If markets fall, you don’t want everything in your portfolio to fall at the same time. A better idea is to have some investments that move in opposite directions – or, are “negatively correlated”.
Correlation is the relationship or connection between two or more assets – meaning when one asset goes up, the other asset moves up, goes down or stays the same. Correlation doesn’t mean that one asset directly affects, or causes, the other one to move. It just measures what generally happens to Asset A when Asset B’s price changes. This is measured with a number called the correlation coefficient, which ranges between -1.0 and 1.0.
A measure of 1.0 means two assets are perfectly correlated. That means that when one asset goes up, the other asset goes up. Think of it this way. The more years of schooling you have, the higher your income will likely be. So, education and income tend to be highly positively correlated.
A measure of -1.0 means two assets are perfectly negatively correlated. So when one asset goes up, the other goes down. For example, the faster you drive the sooner you reach your destination. So speed and “time to destination” are negatively correlated.
A measure of 0.0 means the two assets move independent of one another. The price of mushrooms in Moscow, and the price of tea in Sri Lanka – there’s no link between the two. There’s no relationship between one and the other.
With this in mind you’ll see how market correlations work in interesting ways. For example, in August and September, the Chinese stock market fell 27%. During the same period the Hong Kong stock market declined 15%. You can see the relationship between the two over the past seven months in the chart below.
During this time, these two indices had a correlation coefficient of 0.93 – they’re positively correlated. This means the two markets generally move in the same direction at the same time. This makes a lot of sense, as China’s and Hong Kong’s economies and companies and politics are closely linked. This high level of correlation is an important thing to know if you’re invested in both – if one falls, the other one probably will too.
One way to protect your portfolio from market drops is to have holdings that have a low, or negative, correlation – assets that don’t move together. So when one asset falls, the other asset moves in the opposite direction, or, at least falls less.
This chart compares the Hang Seng Index to gold prices since 2011.
Notice how the Hang Seng Index and gold prices mostly move in opposite directions. The correlation between the two has been 0.20 since 2011 – they’re nearly uncorrelated. This means gold can insulate you against a fall in the Hang Seng Index. On the other hand, the Hang Seng Index will offer some protection when the price of gold falls.
Another example of negative correlation is the Hang Seng Index and the S&P Grains Index (which tracks grain prices) over the past three years. The correlation between the two is 0.01, so when one moves up, the other one (generally) does the opposite.
Sometimes, the price of almost every asset falls, such as during times of extreme distress like the global economic crisis of 2008. But most of the time, investing in different asset classes that have a low, or negative correlation, helps to reduce the overall risk of your portfolio.
So, have a look at your portfolio. If it’s all tea and crumpets, it may be time to shake it up with some pickles and ice cream.