Correlation: Positive One

Bill Parrott |

A diversified portfolio is always recommended. Balancing your accounts between stocks, bonds, and cash will allow it to grow with less risk than a concentrated portfolio.

A key metric to determine how well diversified your investments are is the correlation coefficient. It ranges from positive one to negative one. If two investments have a correlation of positive one, they’ll move in lock step. They will move in opposite directions with a correlation of negative one – one will zig, the other will zag. For example, large cap stocks and mid cap stocks have a high correlation of .97. These two asset classes will rise and fall as if they’re one.  Real estate investments and small-cap value stocks have a negative correlation of .25, so they’ll often move in opposite directions. 

If we apply this metric to food, then swordfish, mahi-mahi, and tilapia are highly correlated.  Swordfish and brussel sprouts are negatively correlated.

Stocks and bonds have low, or negative, correlations and this is one of the reasons your risk will be reduced when you add bonds to your portfolio. In a rising market, investors get frustrated with a high allocation to bonds because it puts a lid on returns. However, when stocks fall, bonds help cushion the blow.

October has been horrible for stocks, bonds, and almost every other publicly traded asset class. During times of duress investors panic and sell their holdings and this causes investments to have a short-term correlation of one, meaning everything is moving in the same direction. When every asset class is in negative territory, emotion overrides logic. During a down draft, investors don’t care about negatively correlated assets, balanced portfolios, or diversified investments because they only want to sell, regardless of long-term consequences.  

What can you do if your portfolio is going down and the “safe” investments are failing to stop the slide? Here are a few suggestions.

Review. Have your goals changed in the last thirty days? The recent fall in stocks has been a disruption in the long-term trend of the stock market, but it’s unlikely it will have a lasting impact on your goals. If you’re not sure your investments are aligned to your goals, then a financial plan can help you quantify them.

Rebalance. During times of market turmoil your original asset allocation has probably moved from its original mooring.  If you purchased an equal amount of stocks and bonds ten years ago, your allocation today is approximately 70% stocks, 30% bonds. The stock market has risen dramatically over the past ten years, and, as a result, your portfolio is now too aggressive based on your original asset allocation of 50% stocks, 50% bonds. Rebalancing your accounts annually will keep your risk level intact.

Purchase. Buying investments when everyone is selling is difficult, but it has proved profitable during the past 200 years or so, so I’m not sure why this time will be any different. Adding money to your investments when they are down makes financial and economic sense. If you automate your investing, it will remove some of the emotion from buying when others are selling.

Nothing. Patience is a virtue and a smart investment strategy. Doing nothing is hard, but it could pay dividends in the future. From March 1, 2009 through October 29, 2018, the Dow Jones has risen 221%. During this run, the Dow had negative monthly returns about a third of the time. It was down almost 8% in May 2012. It had 26 different months where it lost between 1% and 6%. If you panicked during these down months, you would’ve missed the long-term trend of the market for the past nine years.

Disconnect. A walk in the mountains or a stroll on the beach will clear your head. It will also take you away from CNBC and the other media outlets who declare every day a state of emergency. It doesn’t matter if the market is rising or falling, because, according to the “experts”, there’s always something lurking. Distancing yourself from the noise will give you perspective about your investments and your goals.

Give. It’s hard to worry about money when you’re giving it away to help others. Giving will reduce your dependence on money. Ron Blue said giving breaks the power of money. Paul Allen, the co-founder of Microsoft, recently died with an estate worth more than $26 billion. Over his life he gave away billions of dollars to several groups and organizations. His estate is expected to give away another $13 billion to charities when it settles.[1] His giving didn’t hinder his wealth accumulation, in fact, it probably enhanced it.

Over time correlations work and diversified portfolios produce solid gains. Time has benefited stock holders for generations, especially those who have had the courage to buy during market mayhem. Trying to time the market is impossible. Rather than trying to figure out if the market will rise or fall from one day to the next, focus on your goals and how your resources can benefit others.

He who observes the wind will not sow, and he who regards the clouds will not reap. ~ Ecclesiastes 11:4


Bill Parrott is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.