Upfront Notes by Dexter S. Aoki
Chief Investment Officer
808-531-5391 Ext. 350
The value obtained from the asset allocation process* comes
not simply by selecting a variety of asset classes. It comes
from selecting them scientifically in intelligent and effective
ways that maximize diversification benefits. To appreciate
that process, it’s helpful to understand the concept
of correlation.
Correlation represents the extent to which different asset
classes move with each other. If two asset classes have a
correlation of +1, for example, they have perfect positive
correlation – they’ll move simultaneously in the
same direction with the same magnitude. Assets with a correlation
of -1 have perfect negative correlation. Their prices will
therefore move in exactly opposite directions with the same
magnitude. In short, they don’t move in lockstep with
each other – when one asset class “zigs,”
the other “zags.”
By combining asset classes with low correlations, investors
can build a portfolio of very volatile assets while actually
reducing overall risk. The result: A smoother ride to their
financial goals. Correlation therefore is a cornerstone of
advanced asset allocation and Modern Portfolio Theory.
One of the best ways to understand the concept of low correlation
is to review the performance of stocks and bonds over time.
Bonds tend to perform well during periods when stocks are
suffering and vice versa. By combining stocks and bonds into
a portfolio, investors can pursue good returns while lowering
their portfolios’ overall level of risk.
By contrast, investors gain little or no diversification benefits
if they combine two highly correlated assets with correlation
relationships that are equal or close to +1.
For example dividing a portfolio between the S&P 500 and
the Dow Jones Industrial Average would not create a well-diversified
portfolio. The reason: both indices are made up of large-cap
stocks of U.S. firms, so their prices will almost always move
in the same direction.
