WTF is Market Correlation?
In previous blogs, I’ve lamented the fact that financial advisers loooove to use expressions with more syllables than strictly necessary. Look, I just did it in the previous sentence. Six words with more than 3 syllables. This is because we want to appear smarter than we are.
One of those too-long expressions is Market Correlation. All it means is this: how much alike are two different types of investments? Market correlation is measured on a scale of -1 (categories move opposite each other) to +1 (categories move closely in tandem). A correlation of zero would mean the categories have nothing to do with the movement of each other.
Investment categories (aka Asset Classes) are things like stocks, bonds, real estate, gold, international, classic cars, gun collections, wine, and so on.
To use a food example, let’s invent an expression called Tastiness Correlation. The tastiness correlation between tofu and chocolate is -1. The tastiness correlation between chocolate cake and chocolate pudding is +1.
Perfect negative correlations and positive correlations are hard to find, and some of the old rules have changed with time. For example, US and International stocks used to have low correlation to each other, but as world markets have become more connected, that isn’t as much the case.
Why does market correlation matter?
Well, when you are creating a diversified portfolio of many different asset classes, you want the correlation between some of those asset classes to be low. That way, when one type of investment is down (US Stocks), another one may be up (Bonds).
I hope this has helped make one more thing your financial adviser says more understandable!