By Scott Roark, MBA, PhD | July 5, 2019
What is Correlation?
Correlation between asset returns is an important consideration when you are managing portfolio diversification. Correlation is a statistical measure of the relationship between items. An easy example to understand is the correlation between height and weight. Usually, when height increases, weight also increases and you have what is called a “positive correlation” – these two things tend to move together. An example of a “negative correlation” would be between the speed you drive and your gas mileage. Typically, the faster you go, the lower your gas mileage.
How Does Asset Correlation Relate to Portfolio Diversification?
For your portfolio, the goal is to have a well-diversified collection of assets. To be well-diversified means that you need assets that are “negatively” or not highly correlated with each other. When one asset “zigs”, hopefully you have another asset that “zags” and when you put the two together, you have a less volatile (less risky) portfolio.
There is one important implication of this idea in terms of your investment holdings – it is not usually a good idea to have a large portion of your portfolio in your company’s stock. This is because two of your largest assets – the large position you have in the stock AND the “human capital” you have tied up in the company through your employment can be highly correlated. The danger, of course, is that the company goes through hard times and you lose both your job and a substantial portion of your wealth. Employees of once high-flying companies like Enron, Lehman Brothers, Blackberry, GE and many more can testify to the risks involved with owning too much company stock.
At the end of the day, correlation and diversification are all about risk. Early in one’s career as you are building wealth and have a long horizon, there is less concern about risk because there is less to lose and more time to recover. As one approaches and enters retirement, however, managing risk becomes very important because there is usually more to lose and less time to recover. This means it is critical to have a well-diversified portfolio whose assets aren’t highly correlated.
If you’re concerned about portfolio diversification, please call our office to find out how we can help.