For the would-be trader, the time will come when they will feel the need to get to grips with the thorny issue of correlation.
After all, it must be important. Market veterans talk knowledgeably about correlation and negative correlation, murmuring about concepts such as reduced volatility and maximum diversification.
Correlation, clearly, is a very big deal.
But what is it – and is correlation in a portfolio always a bad thing?
Gold and gambling
Put simply, correlation describes the extent to which different assets, whether shares, currencies, commodities or anything else, behave in a similar way. This includes not only the tendency of the assets in question to move in similar directions, either up or down, but to react in a similar way to market-changing events, such as a rise of cut in interest rates or a significant change in commodity prices.
An example of obviously correlated assets would be shares in two companies involved in the same industry, let’s say the gaming industry, in much the same territories. In a nutshell, a regulatory tightening of the rules on gaming, or a new tax, would be likely to depress the stocks of both companies.
They are highly correlated, in other words.
Now let’s assume that, rather than the shares of two gaming companies, the assets in question comprise shares in one gaming company and an investment in gold. Here, it is hard to see any correlation at all. Even were you to suggest that the sort of raging inflationary boom that would lift the gold price would also be likely to see an increase in gambling – a somewhat roundabout argument – you may be proved wrong, there being some evidence that people turn to small-stakes gambling such as slot machines as a diversion when times are cloudy rather than when they are sunny.
A yen for the oil price
Gambling stocks and gold can be said to have zero correlation. Should they move in the same direction, that will be coincidental, as would be their moving in directly opposite directions. Factors affecting bullion prices – geopolitical risks, inflation, the outlook for paper currencies – have little impact on gambling stocks.
When one asset rises, the other falls, and vice versa. Let’s stay with gold and look at its relationship to the US dollar. In an important sense, these are rival assets, given that both find favour as safe havens during periods of turbulence or uncertainty.
Three months ago, on 11 November, gold traded at $1,207.05 a Troy ounce, and is currently $1,311. Over the same period, the dollar/euro rate has declined from €0.8915 to €0.8845.
A negative correlation can be seen also in the relationship between the oil price and the Japanese yen. Japan is an industrial giant with practically no natural resources of its own, thus rises in commodity prices push up the country’s import bill.
Earlier this year, market scepticism about a deal among oil-producing countries to curb production in order to support prices gave way to a more upbeat assessment of the package. The yen/dollar rate had been $0.0093 on 3 January, and the price of Brent crude had been $55.93 a barrel.
By 8 February, the oil price was $62.10, while the yen was trading at £0.0090.
Cash is (sometimes) king
At this point, an obvious objection would be to ask why, if all these positive, negative and zero correlations are known about, everyone doesn’t simply trade on the back of them and get rich?
Alas, in the world of correlations there are no guarantees. You cannot be sure that, for example, a gold-price rise will be bad for the dollar, merely that this is the most likely consequence. Unlike paper currencies, gold is the only monetary asset against which all the other currencies can rise or fall at the same time.
The use of the word “perfectly” ought to raise the alarm – perfection is not something usually associated with the frequently messy and sometimes chaotic world of financial markets. But this does not mean that correlations should be ignored.
All things being equal, attention to correlations, whether positive, negative or zero, can help you put together a diversified portfolio, one in which each of a range of uncorrelated assets is largely insulated from the factors affecting the others.
But two words of warning. One, correlations are not always obvious. A position in the Chinese stock market and in the Australian dollar may seem uncorrelated, but the economic fortunes reflected in stock prices will also impact Australia’s substantial commodity exports to China, with implications for the value of the dollar.
Two, there may be times when correlation can be your friend. Should you have identified a powerful trend, and have a high level of conviction that this is a winning strategy, then why would you want to diversify your holdings? That would merely reduce the size of your gains.
You would, of course, have to be very sure before you abandoned the protection offered by diversification, but there may be occasions when it makes sense to do so.
Finally, it must be noted that there is one asset that is almost completely uncorrelated with any others: shares, commodities, currencies, real estate or anything else. It’s called cash.