Considering ‘correlation’ while investing

When someone pitches a new investment product - the first question we tend to jump on is past returns (which is not a wrong question). However, risk and correlation are two other equally important points when evaluating prospective investments. Risk can be covered on another day. Let’s focus on “correlation” today.

The term ‘correlation’ stands for how closely two variables move together. In finance, it’s used for stocks and asset classes such as gold, commodities, debt, and international stocks.

A high correlation shows that the two investments are moving together very closely. On the other hand, a low correlation shows that the two investments do not move together with time.

For example, a stock that goes up 10% has a 100% correlation with another stock that goes up 10% in the same period. On the other hand, a stock that goes up 10% and another that stays the same have close to 0% correlation.

Also read: Investing in stock markets for first-timers

Why does this matter?

Correlations matter because they show how individual funds or asset classes behave in different market conditions. It’s the best way to gauge how diversified one’s portfolio is. One of the biggest sales pitches in getting investors to invest in certain funds or stocks is diversification. But how does one measure it? It’s via ‘correlation’.

Let’s talk about equity first. Equity is probably the most important asset class in a portfolio. It has delivered the highest returns by a considerable margin over anything else, and it’s the only reliable asset class to combat inflation. The problem with equity is that it’s volatile. Most investors do not have the stomach to handle the high volatility of equity.

Investors feel that by investing in multiple stocks or multiple equity funds - one can lower volatility - but this is entirely incorrect.

All Indian equity funds - large-cap, small-cap or mid-cap have over a 90% correlation- which means they all move together. A good stock market will lead to them doing well and vice versa (hence offering very little diversification in bad times). A good example is March 2020 (Covid crash).

When the markets fell, it didn’t matter what equity fund or stocks investors held. Everything was down 30-40% in a matter of a month.

Why diversify?

This, however, can be avoided by adding non-correlated asset classes to your portfolio - like currency, debt, international equity and debt and others. Most of these have less than 50% correlation - which means that when the stock market is having a lousy year - these asset classes may not.

Hence, your portfolio will be protected from steep declines.

Too much of your money invested in one asset class is bad, leading to higher volatility. Therefore when evaluating investments - keep an eye on the correlation between funds and asset classes.

A portfolio with multiple asset classes is best geared to withstand steep losses coming from any asset class. It keeps portfolios stable, keeps investors less nervous about short-term movements, and helps investors take a 10, 15, 20 year+ investment horizon. If compounding is an investor’s friend, emotions are the enemy. So seek out a low correlated portfolio to keep your emotions at bay while keeping your money growing.

Suppose you look at most investors’ portfolios in more developed markets like the UK and USA, almost all have exposure to multiple countries and multiple asset classes like debt, commodities and currency. India is headed in the same direction.

In conclusion - diversification is essential, and the only way to measure diversification is by looking at correlation.

So choose investments with a low correlation to equity (since it’s the most volatile) and get protection and reduced volatility. This, combined with a periodic rebalancing of your portfolio, is the secret sauce of good investing!

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