#63 Stable portfolio thanks to low correlations

Many investors assume that they are well diversified if they spread their assets across different asset classes or regions. This makes sense in principle, but is only effective if the individual investments do not move in lockstep.

If all positions react in the same way to negative news, the diversification effect is lost. For example, if stock prices in the US collapse, European stocks usually come under pressure as well. In such phases, it becomes apparent that geographical diversification alone does not offer sufficient protection.

What does the correlation of investments mean?

Correlation is the statistical measure of the parallel movement of investments. It is easy to calculate – at least in retrospect. The corresponding scale ranges from −1 to +1:

• +1 stands for perfect parallel movement: both investments always move in the same direction.
• 0 means that there is no linear relationship.
• –1 describes perfect opposition: if one investment rises, the other falls by the same amount.

In practice, strongly negative correlations are rare, but particularly valuable. A security that moves in the opposite direction to the overall market can significantly reduce the volatility of a portfolio.

Stocks usually correlate positively

Basically, practically all stocks have a positive correlation with each other. If a single stock falls on a good trading day, this is usually due to company-specific reasons. The same applies in the opposite case.

In today's globalized world, the stock markets of different continents move very much in lockstep. For example, the correlation between American and European stocks is almost 0.8.

The role of bonds and gold

Government bonds correlate slightly negatively with equities. Interest-bearing securities are therefore generally well suited to reducing the value fluctuations of an equity-heavy portfolio.

Another classic example of low correlation with equities is gold. It is particularly interesting to note that precious metals also correlate only weakly with other so-called «safe» investments. For example, the correlation with US Treasuries in Swiss francs has been only around 0.1 over the last 13 years.

Correlations are not constant

Correlations can change significantly in the short term, especially in stressful situations. One example of this is the liquidity crunch in 2008: after the outbreak of the financial crisis, many market participants needed liquidity quickly. So they sold everything for which there were still buyers. As a result, stock and gold prices fell in lockstep at times. However, while 2008 was a disastrous year for stocks overall, gold made up for its initial losses in the same year.

The year 2022 is remembered even more vividly: at that time, many investors were disappointed that the old logic of «stocks down, bonds up» was no longer valid. Calculated in Swiss francs, the MSCI World Index fell by a good 13 percent. Against expectations, however, US government bonds offered no protection. On the contrary, they lost over ten percent of their value. Gold, on the other hand, proved to be a safe haven and rose slightly in 2022.

A long-term view is crucial

These examples illustrate why correlation data should not be viewed and interpreted in isolation and in the short term. Individual years can be strongly influenced by exceptional circumstances. It is advisable to analyze long periods of time – for example, rolling ten-year periods or even longer historical data series.

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