While a bull market may be good for stocks, is it a good time for all investments? The intuitive answer may be yes, but a bull market can actually negatively affect other investments. The correlation, or relationship, between two different investments can be difficult to determine without historical data and statistical analytical tools. However, there are some basic rules of thumb that can help explain how the different forces interact and how investors can profit from them.
Most investments have a high correlation to market performance. In other words, when the overall market is rising, they’re rising too, so there is less variability between their performance and the performance of the market as a whole.
Other investment classes have a low correlation to market performance. Investments in this category typically include currencies, commodities, and most hedge funds. While these typically carry more risk than investments with a high correlation, they can be good alternatives during periods of uncertainty or bear markets (when the overall market is faring poorly).
Then there are investments with a negative correlation to the market — they rise when the market falls, and vice versa. These are some of the most challenging investments to manage. While they can serve to diversify a portfolio and lower risk, by themselves, they carry the highest risk of all since the investor is betting against the market. Investments in this category include shorted indexes and stock of companies dealing with inferior goods.
While each of these investment classes carries its own risk, combined they can lower your portfolio’s overall risk. When investors combine assets whose returns show low (or even negative) correlation with each other, they can minimize risk while maximizing return (because the investments are not as likely to fall at the same time). In other words, it is possible to be a prudent investor even if your portfolio includes riskier assets — as long as those riskier-yet-higher-yielding investments are balanced with others in a well-diversified portfolio.
We’ve seen lately that diversifying across different industries or international markets is not protection enough for big down days, when almost every stock — domestic or international — gets hit. During these times, stock investors do not have anywhere to turn unless they’ve already hedged their stock portfolios with other asset classes.
A business school student’s dissertation could be written on the correlation between investment classes; and in the end, sometimes the basics of investing are most important to remember: those seeking higher returns will have to bear higher risks.
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This newsletter was prepared by Integrated Concepts Group, Inc. The opinions expressed in this newsletter are for general information only and are not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. The views expressed are those of the author and may not necessarily reflect those held by PlanMember Securities Corporation. Material presented is believed to be from a reliable sources and PSEC makes no representation as to it accuracy or completeness.