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OCTOBER 4, 2010
FUNDAMENTALS OF INVESTING

Why the Math of Correlation Matters

These measurements can aid in the hunt for assets that zig when others zag, thereby reducing portfolio
volatility
By JON N EL L E MAR TE

Many mutual-fund investors strive for diversified portfolios, but few fully grasp a concept that is key to
achieving that aim: correlation.

Correlation is the extent to which assets perform in

Journal Reports
relation to one another. For instance, it's widely
Read the complete Quarterly Investing in
considered good practice to reduce volatility in your
Funds report .
portfolio by investing in a variety of assets whose values
S&P 500 Correlations
rise and fall independently of one another.

If your investments move in lock step, or are highly

correlated, "you'll either be all right or all wrong," says
Linda A. Duessel, equity market strategist at Federated
Investors Inc.

Financial advisers say they love to analyze correlation

but rarely discuss it in depth with clients. At a time when
many assets are experiencing unusually high correlation
View Interactive —a trend that has pummeled some portfolios—it's a
topic worth grasping.
Diversifying a stock portfolio requires
investments that don't move in lock-step. See
how various indexes would have correlated
"It has become more important over the years, because
to moves in the S&P 500. the world is more interconnected, for people to
More photos and interactive graphics understand on a macro level how things relate to each
other," says Cassandra Toroian, president and chief
investment officer of Bell Rock Capital LLC, an investment firm based in Rehoboth Beach, Del. "People
look to use these kinds of theories because they're trying to smooth out the volatility in their
investments."

Here is what you should know about correlation:

How is correlation measured?

Correlation is determined by comparing the returns or general movements of two assets or products.
Using what's called a regression analysis, an adviser produces a number, from 1 to negative 1, that
displays how likely one asset is to move similarly to another.
 A correlation close to zero means the performance of
one asset has little or no connection to that of the other.
A correlation of 1 is a perfect positive correlation,
meaning the two assets always move in sync—in the
same direction, and at a scale that doesn't vary. For
instance, Asset A will always move at twice the
magnitude of Asset B. A correlation of minus 1 is a
perfect negative correlation. The assets move in
opposite directions at a scale that doesn't vary.
David Plunkert
What time periods are used in the
calculation?
It's common for analysts to compare the monthly returns of different assets over years, but the figure
can also be calculated using daily or weekly returns.

But keep in mind that correlation is a

fluid measure. While some assets or
securities exhibit general trends of
correlation over time, the exact
measure often changes depending on
the period. For example, a
Morningstar Inc. analysis shows the
correlation between intermediate
U.S. bonds and the Standard &
Poor's 500-stock index has
historically been low—a mere 0.08 if
you look over a period of more than
80 years. But that changes to minus
0.39 if you only look at the past 10
years, showing an increased
tendency to move in opposite
directions. The change reflects how
often investors have sought the
safety of bonds when stocks have
fallen, and then sold the bonds when
stocks looked more favorable again.

Another thing to be wary of: Correlation often surges in a crisis. In the 2008 crash, for instance, many
assets across all classes exhibited unusual correlation when they headed down.

Do I want assets that are negatively correlated or uncorrelated?

A key aim of asset allocation is to invest across a range of sectors, countries and asset classes that earn
decent returns but are relatively uncorrelated. That way, if one asset in a portfolio suffers, the rest might
be unaffected. For example, Treasury inflation-protected securities, or TIPS, usually move unrelated to
the performance of the S&P 500.

Sometimes, investors will choose assets that are negatively correlated in order to hedge risk. If you don't
want to sell your U.S.-stock funds but want to temporarily cut your stock risk, you might invest in an
inverse fund designed to perform well when a stock index does poorly.
inverse fund designed to perform well when a stock index does poorly.

Such strategies are only recommended in the short term because they essentially cancel out returns.
Holding too many negatively correlated assets can be a little like trying to hit the gas while slamming on
the brakes, says Jonathan Satovsky, chief executive officer of Satovsky Asset Management LLC, a wealth-
management firm in New York.

So what assets have low correlations?

The core of many portfolios is exposure to large U.S. stocks and intermediate-term bonds. Over the past
10 years, the S&P 500 and the Barclays Capital U.S. Aggregate Bond Index have shown a minus 0.07
correlation. (The correlation is a positive 0.25 if you look back 35 years, but that is still a weak
relationship.)

Even weaker is the connection between Treasury bills and the S&P 500, minus 0.05 over the past decade.

Where can I find information on correlation?

Most online correlation calculators are available only for financial advisers. So, one option is to ask your
financial planner.

Tools for individuals include assetcorrelation.com, which finds correlations between assets and between
asset classes.

R-squared, a measure found on Morningstar.com, shows strength of correlations between funds and
benchmark indexes, but not directions of movement. The scale ranges from 0 to 100.

Ms. Marte is a staff reporter for The Wall Street Journal in New York. She can be reached at
jonnelle.marte@wsj.com.

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