Investors Want Non-Correlated Assets Until They Experience Non-Correlation

with No Comments

Investors Want Non-Correlated Assets Until They Experience Non-Correlation

Craig L. Israelsen wrote an article in Financial Planning Magazine titled, “Advisors: Embrace the Winners … and Losers“:

While it would be fun to hold a Portfolio in which all of the asset classes were going up at the same time, it would be a nightmare if they were all moving down at once.

To protect against epic losses, advisors and their clients seek uncorrelated returns — asset classes that behave dissimilarly so that a portfolio’s ingredients don’t all move in the same direction at the same time.

But diversified portfolios should be built with the knowledge that including uncorrelated assets means always having to endure pain in part of the portfolio. That part will be going down or remaining flat, since it tends to move differently from the uncorrelated part that is going up.

Of course, there is an irony here: While many investors say they want a low-correlation portfolio, they don’t want to actually experience a low-correlation portfolio. The experience of a low-correlation portfolio is the experience of owning asset classes that are making you happy while others are making you sad. When that’s happening, you have low correlation. Enjoy it.

Correlation is a measure between 1.00 and -1.00 of how much two sets of data move in sync with one another. A correlation of 1.00 means that they always move in sync with one another. A negative correlation means that they usually move in opposite directions.

There is a science to the rebalancing bonus such that non-correlated assets produce both a smoother and a better return in the midst of an inherently volatile stock market.

But as Israelsen’s article points out, investors don’t want the experience of owning whichever assets are under performing when they aren’t moving in sync with one another.

Learning to enjoy the non-correlation means learning to enjoy the ability to sell what has gone up and buy more shares at an even lower price of what has gone down. And learning to enjoy doing that often for a several quarters or even a few years in a row. This is the contrarian discipline of buying low and selling high.

The stock market is inherently volatile. If you had a portfolio where everything goes up at the same time, it will all come down at the same time. Avoid that kind of portfolio. Instead, it is better to learn to enjoy the steady climb of a balanced asset allocation. By not spiking and crashing all the time like a fully-correlated portfolio would, it will grow your wealth more quickly and steadily.

Photo used here under Flickr Creative Commons.

Follow David John Marotta:

President

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818…)