Correlation in investing
In a branch of mathematics, statistics, correlation is an established fact. This term is also often used on the investment market. What is the substantive meaning of correlation in investing ? In this blog you can read all about it.
Correlation: What is it?
Correlation is the relationship between two variables. In investments, it is usually about the relationship between bonds and shares . The consequences of a change in the price of shares for the bond prices are then investigated. To show the mutual relationship of the variables, the correlation coefficient is used, a value between 1.0 and -1.0. It is possible to speak of negative or positive correlation and the absence thereof.
A positive correlation means that when stock prices rise, bond prices also show an upward trend. A correlation with a value of +0.5 indicates that when stock prices rise 2%, bond prices rise 1%, or half as much.
A negative correlation means that bond prices fall when stock prices rise. A correlation of -1.0 indicates that when stock prices rise by 2%, there is a proportional fall in bond prices of 2%.
In case there is no correlation, this means that there is no relationship between the price movements of stocks and bonds. If the stock prices then go up, this has no effect on the bond prices. A so-called negative correlation is indicated by the zero value.
Correlation in investing
The standard deviation can be calculated in investments by establishing the correlation within the portfolio . The standard deviation is the standard for the sensitivity to fluctuations, the so-called volatility , and for the level of investment risk.
It is possible to reduce the risk within an investment portfolio by spreading your investments in order to create a favourable correlation. This is the case when the correlation value moves to -1.0. If the correlation is -1.0, the loss of one investment product can be fully compensated with another investment product. It is not very realistic to think that this eliminates all risk. However, it is a fact that correlation occupies an important place in contemporary insights for setting up an investment portfolio and forms the basis of modern portfolio theory.
Correlation and Investing: Investment Markets
In the investment world, it is common practice to discover correlations between the most traded currencies and commodities.
There is a clear correlation between the Canadian dollar and the price of oil. This is because Canada is a large exporter of oil. The Japanese yen, on the other hand, has a negative correlation with the price of oil, because it is dependent on imports for oil. The Australian dollar has a significant correlation with the price of gold. The New Zealand dollar, in turn, is correlated with futures that relate to agriculture, such as cattle or corn futures.
Examples of correlations between markets
Below we will list some well-known correlations between various investment markets.
- The correlation between oil and airline stocks. Higher fuel costs for airlines are caused by an increase in oil prices. Oil prices have a direct impact on the price of jet fuel and diesel. This increases the total costs that an airline has to make. This is then passed on to the consumer by increasing the price of a plane ticket. This trend has the greatest impact on American airlines. Unlike airlines in Europe and Asia, these companies are not insured against an increase in oil prices.
- The correlation between oil and Delta Airlines stock.
- The correlation between gold and various stock markets.
There is still a debate about the exact relationship between the price of gold and stock prices. The prevailing view is that these two investment markets generally have a negative correlation: when stocks rise in value, the value of gold falls. This is also the case the other way around. This can often be assumed because gold is seen as a safe investment. If investors decide to invest defensively, they prefer to invest in gold rather than in high-risk stocks. - The correlation between gold and S&P 500.
Why is correlation so important to investors?
In the investment world, the correlation between the various investment markets is examined in detail to prevent excessive fluctuations in an investment portfolio.
After all, asset management is focused on the right combination of investments with a higher or lower or even negative correlation to limit volatility. By choosing investments with a low correlation, you reduce the chance of fluctuations in your portfolio. In practice, this means that an investor has the opportunity to invest in investments with a higher risk, if there is a willingness to accept limited volatility. You can then start investing aggressively.
This method, where investments are combined from high to low and even negative, is also called portfolio optimization. In this way, the possible fluctuations of an investment portfolio can be made more acceptable.
Investment strategies based on correlation
In addition to recognizing the impact that positive and negative correlations have on stock markets, it is crucial for investors to enter into certain transactions at the most opportune time. There can always come a time when the correlation breaks, and if an investor does not recognize the change quickly, such moments can indeed lead to unpleasant surprises.
Taking correlation into account is an important step in technical analysis for investors who are looking to diversify their investment portfolio. When there is great uncertainty in the stock markets, a common strategy is to rebalance a stock portfolio by simply eliminating some investments with a positive correlation and adding more investments with a negative correlation.
The following situation is then created: the fluctuations in market prices, which compensate each other, reduce the risk for the investor and thus also the return. At the moment that the market reaches equilibrium, the investor can start closing the negatively correlated positions.
An investment strategy focused on financial products with a negative correlation will have in its portfolio a stock and a put option on the same stock. The more the stock price falls, the higher the value of a put option becomes.
Risk management in correlation-based investment strategies
To limit the negative effects of losses, effective risk management and consciously entering into certain investments are of great importance. By taking advantage of modern portfolio theory and investing in positively correlated markets, it is possible to reduce the overall risk of your total investment portfolio and even increase the profit of your total investments.
This investment strategy will make it easier to limit fluctuations in your portfolio and to bridge small profit fluctuations, because certain markets will continue to have a strong correlation. You should always check how the relationship works out in practice and be aware that the profit may decrease, if the market prices diverge more and the correlation weakens. If this situation occurs, it is important to stop this investment and choose another strategy to respond adequately to the changes in the investment market.
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