This post is a preview of WorthPointe’s e-book Evidence-Based Investing: Separating Fact From Fiction, written by Certified Financial Planner™ Scott O’Brien. In Evidence-Based Investing, Scott discusses the myths and misinformation that most often slow or halt our financial goals. Get your complimentary copy of Evidence-Based Investing here.
Correlation is the interdependence of certain quantities. For our purposes, think of it as how different investment assets interact with each other.
Think of practicing the piano and how well you play — there is a positive (or high) correlation between how much you practice and how well you play.
The same is true for surgeons and golfers. The more you practice any task, the higher your skills become at it.
Negative, or low, correlation can be explained with the following example: The more you criticize someone, the less likely they are to be your friend and the higher the negative correlation between the two.
A zero correlation would be if two things are unrelated or random. If the correlation concept were applied to basketball players:
- ● A correlation of -1 is when two parts behave very differently — like a 6’1″ left-handed point guard and 7’4″ right-handed center.
- ● A correlation of +1 is when two parts behave exactly the same like twin right-handed brothers who play point guard.
- A correlation of 0 means the items being studied move in a random matter — two random people from the audience running around on the court during a game.
You should look to invest in assets with a low correlation. This often seems counterintuitive. Wouldn’t you want your investment assets to all go up at the same time? Well, in theory, yes.
But in the real world of your financial future, that would also mean your investments would all go down at the same time and that’s a problem.
Everyone is happy when investments are going up, but despair surfaces when asset prices fall.
Most investors look at their portfolio and see the ones that have gone down or aren’t doing as well as others and think, “I should sell that one and buy this other one that’s doing well.”
If you find yourself feeling that way, you’re falling into the trap of believing what is going up will continue to go up and what is lagging will continue to lag. The evidence from tracking real-life financial portfolios over a lifetime says the “principle of reversion to the mean” will surface at some point, and the opposite will happen.
Reversion to the mean is the theory that prices and returns eventually move back toward their mean or average. For example, the S&P 500 has a historical average of close to 10%.
If the S&P 500 Index were to have five very good years in a row and averaged over 10%, then the reversion to the mean theory would say there is a high probability the index will start to produce lower returns as the performance numbers return to their historical average.
When building a portfolio, you want to combine assets that have low correlations to each other. Some are going up and some are going down. The goal is for your portfolio to travel on a smoother ride with lower volatility and risk. That’s your goal, but it’s difficult to achieve.
Overall risk in a portfolio isn’t the average risk of each of your investments, risk can actually be less if your investments don’t move together.
Read the rest in Evidence-Based Investing. Get Your Complete Copy of the Book Now.
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