CORRELATIONS AND YOUR PORTFOLIO

Deborah Laemmerhirt  203.994.4297

The purpose of diversification is to combine assets with low correlation in order to reduce the risk and volatility in your portfolio. Correlation is a statistical measure of how one asset class performs in relation to another asset class.

Correlations can range from +1 to -1. A correlation of +1 means the two assets move very closely together in the same direction. Combining assets with a high positive correlation will not provide much risk reduction. A correlation of -1 indicates the assets move in opposite directions, a rare event in the investment world. A correlation close to 0 means no relationship exists in the price movements of the two assets. Combining assets that are not highly correlated can help reduce a portfolio's volatility. The lower the positive correlation or the higher the negative correlation, the more risk that is potentially reduced.

Would combining assets with low correlations help during market corrections? In 2002, the S&P 500 had a -22.1 percent return, while long-term government bonds returned 17.84 percent.** Keep in mind that combining assets with low correlation is a defensive strategy. Your return will always be lower than if you had only invested in the higher performing asset.

When selecting investments for your portfolio, don't just look at their risk and return characteristics. Also consider the diversification aspects for your overall portfolio. While correlations change over time, general observations include:

    Stocks tend to have a low positive correlation with corporate and government bonds.

    Short-term bonds tend to have a low correlation with long-term bonds.

    Stock markets around the world are all positively correlated to some degree. In general, European stock markets are more closely correlated to each other and the U.S. markets than to markets in Japan or Asia. Correlations between developed countries tend to be higher than correlations between developed and emerging countries.

    Real estate tends to have a low correlation with stocks and bonds.

* Source: The CPA Journal, November 2003. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Foreign stocks are measured by the EAFE Index, emerging market stocks by the World Bank Global Index and Emerging Markets Free Index, real estate trusts by the National Association of Real Estate Investment Trusts, and bonds by the Lehman Brothers Aggregate Bond Index. Investors cannot invest directly in an index. These correlations are presented for illustrative purposes only and are not intended to project the performance of a specific investment.

** Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates. These returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment. Past performance is not a guarantee of future results.