The reason for the low correlations is that most of the time economic and political conditions impact the various asset classes in different ways. That explains the low long-term correlations. However, in times of global crisis, all risky assets tend to correlate highly. And that leads us to the important lesson the markets teach us.
Correlation of Returns. Prudent investors building portfolios that include asset classes that have low correlation the measure of the strength of the linear relationship between two variables.
Two assets are positively correlated means that when one asset produces above average returns, the other tends to also produce above average returns. Conversely, negative correlation means that when one produces above average returns, the other tends to produce below average returns.
The recent rise in correlations is a result of the financial crisis, nothing more. We have had crisis in the past, and we will have them in the future. And each time the correlation of risky assets will rise, as they always have done. It is important that investors understand that correlations are not static — they do drift.
In a perfect correlation, two investments will always change value in unison; in a perfect negative correlation, they 'll always change value in opposite directions. Of course, perfect correlations of either type are virtually impossible, but the scale helps you get a read on relationships.
Positive correlation coefficients indicate that, on average, returns move together, whereas negative coefficients indicate that more often than not, they move in opposite directions. A correlation coefficient close to zero indicates there is no statistical relationship between the two series.
Prudent investors building portfolios that include asset classes that have low correlation the measure of the strength of the linear relationship between two variables. Values can range from +1.00 (perfect correlation) to -1.00 (perfect negative correlation).
Most of the time, risky asset classes do not exhibit very high correlation. And many even have very low correlations. Among the asset classes that on average have low correlation with U.S. equities are real estate, international small-cap stocks and emerging market stocks.
The financial media has been filled with stories about the rise in correlations. The story goes something like “we are becoming one global integrated economy ….” Thus, the benefits of diversification are greatly reduced. It seems that this has even become the new conventional wisdom — an idea that is so accepted that it goes unchallenged.
It is important that investors understand that correlations are not static — they do drift. And correlations are likely to rise to very high levels during times of crisis.