Personal Finances for 2008: Assessing Asset Correlations
February 7, 2008
Many investors understand the basic premise of diversifying their assets to reduce market risk. By holding different securities, the impact of an adverse move in one security is usually dampened by less extreme moves in the other securities. The ideal scenario is when moves downward in one security is accompanied by moves upward in another—that is, when the investor holds negatively correlated assets.
You have to consider a few different things when creating a reduced risk portfolio. First, there’s the business cycle. There are times when different asset classes or sectors all move in the same direction. Investors need to have a game plan to address such market conditions. When moves are to the downside do you hold more cash or seek out relatively strong performers to minimize losses? When assets move upward together do you seek out more aggressive returns or keep an eye out on risk by accepting more average returns?
The second thing an investor must consider is the extent to which they can actually time market transitions. Using more aggressive securities is a great approach when things are bullish, but downward reversals can be abrupt and severe. Without the use of objective indicators to signal an exit for such positions, gains can quickly turn to losses.
The last consideration is the one that really drives things—what’s appropriate for an investor from the standpoint of their individual constraints (i.e. when the assets are needed) and preferences (i.e. ability to sleep at night when the markets go down). This two-part article looks first at assessing portfolio assets. Next month, a way to apply portfolio protection is addressed.
Correlation
The starting point for any investor is to understand how different securities move relative to others in the portfolio. Correlation is a measure used to do this by providing a numeric value that links the movement between two securities (both relative magnitude and direction). Comparing the returns for two assets, correlation values are interpreted as follows:
- Strong positive correlation (+0.80 to +1.0): asset returns move upward and downward together. There is one-to-one movement when correlation is equal to +1.0
- Not correlated (0): There is no definable relationship between the movement of returns
- Strong negative correlation (-0.80 to -1.0): asset returns move in opposite directions. There is one-to-one movement in the opposite direction when correlation is equal to -1.0
Correlation values between the referenced ranges suggest a weak relationship. If you have a spreadsheet program, you can perform correlation analysis on pairs of assets by completing these steps:
- Download daily or weekly close data for the two assets—check Yahoo finance or your charting package for data,
- Calculate the daily or weekly returns for each,
- Use the spreadsheet’s correlation formula on the return data—in Excel: =correl(data set 1, data set 2)
As an alternative, Optionetics Platinum customers can use the platform’s Correlation Analyzer to obtain this value for all asset pairs in a portfolio using a 250 day period (one trading year). In addition to considering a specific correlation value for two assets, you want to consider how much money you have invested each.
Portfolio Dynamics
Using the S&P 500 Index (SP-500) as a portfolio benchmark and downloading approximately ten years of daily closing data* for SP-500 and SPY, the S&P Select SPDR exchange traded fund [ETF], a +0.965 correlation is calculated on the returns. So when SPX goes down 1%, you expect SPY to also go down by approximately 0.97%. It’s not that exact on a day to day basis, but it’s a useful calculation when there’s no significant change in the way an asset moves.
If you have a $100,000 portfolio with $95,000 in assets that have a strong positive correlation with SP-500, you’ll take little comfort with a slight rise in the $5,000 asset if there’s a sharp decline in the S&P 500 Index. Basic portfolio diversification considers asset correlation in tandem with the actual investment allocation in those assets.
Option strategies provide a portfolio hedge using correlation concepts in the form of delta. In addition, the leverage provided with these securities reduces the percent of portfolio dollars that need to be allocated to the strategy. However, applying such strategies can benefit from the use of unbiased market timing indicators so that your net gains are not eaten up by option premiums.
* TC2000 was used to obtain closing data.
To access other articles written by Clare White, please click here.
Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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