Un-Correlated Asset Classes Reduce Risk

Risk is reduced because the asset classes are “non-correlated” over time, i.e., they all have positive returns but don’t move in the same direction at the same time.  Correlation is the statistical measure of co-movement between assets.  A higher number indicates higher correlation, and less diversification benefit, while a lower number indicates lower correlation or more diversification benefit.  Correlation can range from a +1.0, perfectly positively correlated, to -1.0, perfectly negatively correlated.  Correlation usually runs somewhere in between the two extremes.

Consider these return series results. 

Assets A and B are highly correlated, +.97, while assets C and D are uncorrelated, -.41: 
Asset A
Asset B
Asset C
Q1 6.0% 4.5%     12.0% 0.3%
Q2 -3.0% -2.5%     -4.0% 3.0%
Q3 5.0% 6.0%     6.0% 1.2%
Q4 -0.6% -0.6     -3.9% 0.0%
  Correlation A/B   0.97     Correlation C/D   -0.41

The return and risk table of a portfolio of 50 percent of Asset A and 50 percent of Asset B has higher risk or volatility than a portfolio of 50 percent of Asset C and 50 percent of Asset D, although their returns are the same:

Risk Return

A correlation matrix of our base asset classes is shown below. Correlations typically change unpredictably over time and can be very high during systemic crisis such as the financial crisis of 2008-2009.


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