At e360 Power, we are all about uncorrelated assets. We know that this is one of the best ways to diversify your investment portfolio, and we'd love to tell you all about how it works. Let’s get right into it.
What Is Asset Correlation?
What is correlation in investments? Asset correlation is a measure of how closely two investments move to each other. There are three types of asset correlation: positive correlation, zero correlation, and negative correlation.
A positive correlation means that when one investment goes up, the other investment also goes up. Don't be alarmed if you find yourself attracted to someone who is also attracted to you - it's just a positive correlation. This phenomenon occurs when two variables are positively related, meaning that as one increases, the other also increases. An example would be Grubhub and DoorDash.
A zero correlation (also known as non-correlated or uncorrelated) means that the movements of the two investments are unrelated. Zero correlation means that there is no relationship between two asset classes. So if asset A goes up by 1%, asset B can go up or down by any amount and it would still be considered zero correlation. An example would be the relationship between manufacturing and social media.
Studies have shown that a portfolio of uncorrelated assets will tend to be more stable and have less volatility than a portfolio of correlated assets. This is because when one asset class goes down, the other asset class may go up, offsetting some of the losses. Uncorrelated assets are the best type of asset, for this reason, offering potential returns with the least amount of risk.
A negative correlation means that when one investment goes up, the other investment goes down. A traditional example of this can be seen with stocks and bonds. When stock prices are rising, bond prices usually fall, and vice versa. Recognizing negative correlations between assets in the market can be helpful to make informed buying decisions.
Why Is Correlation Important?
When it comes to investing, correlation is everything. The correlation of two assets simply measures how closely they move to each other. A high correlation means the assets move in sync, while a low correlation means they move independently of each other. Why does this matter?
Well, if you're diversifying your portfolio (and you should be), you want to include assets that don't move in the same direction. That way, when one asset takes a hit, the others will help offset the losses. For example, if you own stock in company A and company B, and company A takes a nosedive, the odds are good that company B's stock won’t do the same. So even though both companies are down overall, your portfolio is less affected by the performance of Stock A. That's the power of diversification.
Examples of Non-Correlated Assets
Since uncorrelated assets are the preferred form of asset, it's important to recognize them in the market and know how to use them. Let's talk about some examples of non-correlated assets so that you can get more familiar with how it all works.
The power industry is a great example of an asset class that is not closely correlated to traditional markets equities or fixed income. This is because dispatch of power demand is generally independent of what's happening in the stock market. After all, people still need to use electricity even when the stock market is down.
Natural gas is another non-correlated asset that can be a great addition to a portfolio. The price of natural gas is affected by factors such as weather and supply/demand, which are not closely tied to the stock market. As a result, natural gas prices tend to behave based on their own fundamentals, even when the stock market is volatile.
Real estate and REITs are part of another asset class that is not closely correlated to the stock market. This is because the demand for real estate is driven by factors such as population growth, interest rates, and the overall health of the economy. While the stock market can be affected by these factors, it is not as closely tied to them as real estate is.
Gold And Other Precious Metals
Gold and other precious metals are also part of the uncorrelated asset category and are often seen as a haven during economic downturns. This is because they are not closely correlated to anything specific in the stock market or to other asset classes.
Uncorrelated Assets and Risk Management
Managing your risk is crucial for making appropriate investments, so understanding the concept of correlation is imperative. Two assets are uncorrelated if the movement of one asset doesn't predict the movement of the other. In other words, they move independently of each other. This is important because it means that when one asset goes down, the other asset is more likely to go up (or at least not go down as much).
Of course, uncorrelated assets don't always move in opposite directions - sometimes, they both go up or both go down. But over the long run, having a mix of uncorrelated assets can help to smooth out the ups and downs of the market and improve your chances of achieving your investment goals.
This is because even though each asset has the potential to lose value, the overall risk of your portfolio is reduced.
Is Your Portfolio Diversified?
Having a diverse portfolio is important for some reasons. First, it helps to diversify your risk. By investing in a variety of assets, you can minimize the impact of any one asset’s performance on your overall portfolio. Second, it can help to maximize your return. The Modern Portfolio Theory suggests that the correlation of two assets is an important factor in determining the optimal mix of assets for a portfolio.
By including a mix of uncorrelated assets, you can potentially increase your return while reducing your risk. Finally, having a diverse portfolio can also help to hedge against inflation. You can protect your purchasing power over time by investing in commodities, real estate, and other inflation-hedged assets. So whether you're looking to diversify your risk, maximize your return, or hedge against inflation, investing in non-correlated assets is highly recommended.