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What does correlation mean?
Correlation between asset classes: This is why diversification is important
The Choosing the right asset classes is an important factor when it comes to building a successful portfolio. But how are different asset classes related and how do they influence each other? In this article, you will get a look at the Correlation between asset classes and the Importance of diversification.
At the same time you learn, what correlation is and how it relates between equities, bonds and other asset classes. You will also learn why the correlation between asset classes has increased in recent years and how it affects the performance of the market. Diversification of a portfolio can have an impact.
Table of contents
What is correlation? Correlation simply explained
Before you delve into the details of correlation between asset classes, you must first understand what correlation means. Correlation refers to the Relationship between two or more asset classes and how they compare to each other.
The Correlation coefficient (-1 to +1) indicates, how close or loose this relationship is. A value of +1 means that two asset classes perfectly positively correlatewhile a value of -1 a perfect negative correlation represents. A value of 0 means that no correlation exists between the asset classes.
Why can a negative correlation advantageous be? A negative correlation between two asset classes means that they are move in opposite directions. So when one asset class rises, the other falls and vice versa. Such a negative correlation in a portfolio is advantageous, as it reduces the Reduce risk can.
Correlation between shares and bonds
Shares and bonds are two important asset classes that are often Basis for a balanced portfolio serve. A mix of equities and bonds can help reduce risk while providing a reasonable return.
Viewed historically shares and bonds have a negative correlation which means that they are moving in opposite directions: When stocks fall, bonds often rise and vice versa.
However, factors such as interest rate hikes, inflation and economic cycles can influence the correlation between equities and bonds.
Why is a Mixture of shares and bonds make sense in the portfolio? A mix of equities and bonds in the portfolio makes sense, as it can reduce the Reduce risk can. Shares are usually riskier than bonds because they are more volatile and have higher fluctuations. Bonds, on the other hand, are usually safer as they offer a fixed return and often fluctuate less.
Having a balanced mix of stocks and bonds in your portfolio can reduce risk, as the fluctuations of stocks and bonds can offset each other.
By the way: If you want to learn exactly how to build up a portfolio in a structured way and even simulate it, you should take a look at the FinanceTimetable throw.
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Correlation and active vs. passive investment strategies
Active and passive investment strategies have different effects on the correlation in the portfolio. While active investment strategies mostly aim to achieve through Targeted selection of asset classes and titles a higher yield to achieve, are based passive investment strategies on the replica of a broad market or index.
A active investment strategy refers to the Purchase and sale of securitiesbased on a forecast of the market or a specific asset class. In short, you perform a form of trading. The Correlation between the asset classes has great importance in this strategyas it strongly influences your decisions to buy or sell.
With a passive investment strategyas you do with index funds, you meet No active buy or sell decisions within the index. This strategy helps to reduce risk by relying on broad diversification that takes into account the correlation between asset classes.
Other asset classes and their correlation to each other
Besides shares and bonds, there are many other asset classes that you can include in your portfolio to diversify your investments.
Commodities, real estate and currencies are just a few examples. If you own these asset classes, you need to understand how they correlate with each other.
Commodity prices can be influenced by natural disasters or political events in commodity countries, for example. Property prices often depend on factors such as interest rates, business cycles and supply and demand. Currencies can be influenced by various factors, such as interest rates, inflation and the exchange rate.
Political events, natural disasters and market changes can have a huge impact on the correlation between all asset classes.
There are No standard correlation between all asset classes. Rather, it depends on the specific factors that influence its price movements. Sufficient diversification of your portfolio can help to reduce risk by Combine asset classes with low or negative correlation.
Rising correlation of asset classes
In the years gone by is the Correlation between asset classes increased. On the one hand, companies have become increasingly internationalised and generate a large part of their turnover abroad. As a result, the Swiss SPI and the MSCI World Index often fluctuate similarly.
In addition, the increasing popularity of passive investment strategies and index funds has led to the fact that more and more investors are investing in the same asset classes. Automated trading strategies and algorithms are other causes and reasons that influence correlation between asset classes.
On this topic, Prof. Erwin W. Heri has written a detailed video created. Feel free to take a look at it to better understand the topic.
Are you interested in how to calculate correlation? Then write it in the comments!
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Correlation and diversification: the foundation of a balanced portfolio
What does correlation mean? In summary, it can be said that Correlation focus on the Relationship between two or more asset classes and shows how they develop in comparison to each other.
The Correlation between asset classes is a Important factor in the decision to include certain asset classes in a portfolio. Sufficient diversification can help reduce your risk and help you achieve long-term returns.
However, blindly spreading your investments across as many asset classes as possible does not necessarily reduce risk.
The Choosing the right asset classes and a balanced diversification are the foundation of a successful portfolio.
If you want to learn exactly how to build a portfolio in a structured way and even simulate it, you should take a look at the FinanceTimetable throw.