MPT & Correlation

Last time we discussed correlation, with respect to weight training with fat pugs. Delving deeper into the subject, correlation is the extent to which one asset’s performance mimics another asset’s performance. The following line graph illustrates correlation.  Consider how the performance (investment return) of the S&P 500, in blue, is highly correlated to the performance of international companies, in purple. The blue and purple lines rise and fall in value simultaneously. When blue is up, purple is up. When blue is down, purple is down. Thus, the performance of domestic equities (blue) and international equities (purple) are highly correlated. 

As mentioned in the previous post, long-term Treasuries are negatively correlated to the S&P 500. The red line (long-term Treasuries) makes the opposite change in value relative the blue line (the S&P 500). When blue is up, red is down. When blue is down, red is up. 

In the chart above, commodities (oil & gas, precious metals, etc.) exhibit little relationship to the other asset classes just mentioned. Consider how the green line (commodities) rises and falls relatively independently of the other asset classes.

According to Modern Portfolio Theory (MPT), a portfolio of investments functions best when it is diversified among assets that have low, no, or even negative correlation to each other. Since every asset suffers from periods of poor performance, and since every asset worth investing in grows over time, diversification across uncorrelated asset classes will ensure consistent portfolio growth.

Lastly consider that Modern Portfolio Theory is just that - a theory. While some investors swear by its risk reduction properties, others dismiss it - with some preferring a strategy of value investing. In future posts, value investing will be explained, especially with respect to its pros and cons over Modern Portfolio Theory.