What is correlation?
Correlation is a measure for how two things change relative to one another. Things that are positively correlated tend to change together; when one increases the other also increases. Things that have no correlation move randomly relative to one another. Imagine you owned a food truck. You will probably sell more ice cream when it’s warmer. Thus, ice cream sales and temperature are positively correlated because, as temperature increases, so will your ice cream sales.
Why is correlation important?
If your food truck only sells ice cream, you will end up with a lot of sales in the summer but few sales in the winter. It may be difficult to keep the business open in the winter with so few sales over a prolonged period of time. But if you sold items that did as well or better when the temperature gets colder – like hamburgers or hot chocolate – that may help you survive those tough winter months. Adding products that have no correlation or negative correlation with temperature to your menu could reduce the fluctuations in your sales throughout the year. This would result in a steadier stream of income that would be easier to stick with over the long term. Take this concept to investing. If all your investments were positively correlated – like ice cream sales and temperature – when one of your investments went down, they all would. For example, in 2008 US stocks were down 40%. If your portfolio was only invested in US stocks, that negative return may have scared you. It would have been tough to stay invested during this period and benefit from the market recovery that followed. Studies have shown that overreacting to market movements can cause investors to underperform the market by ~4% per year. Having investments that don’t move together can decrease the highs and lows of your investment experience – just like adding hot chocolate or hamburgers to your menu – which will make it easier to stick with.
Low correlation can also reduce the likelihood of a bad outcome right before you want to use your money. Imagine you had planned on retiring at the end of 2008. The impact to your savings from the Financial Crisis could have forced you to work a few more years or rethink your retirement lifestyle. A portfolio consisting of investments that move independently from one another may have softened the blow from such an untimely loss to the US stocks in your portfolio, allowing you to maintain your retirement plan.
