The Benefits And Dangers Of Correlation

Correlation can be very beneficial for a portfolio. It allows you to increase returns while keeping risk constant, or to decrease risk while keeping return constant i.e. adding positive return, non-correlated instruments or strategies to your portfolio should increase risk-adjusted returns.

That is the theory. It works in practice too, most of the time. Unfortunately, correlations are not constant. For example, the WSJ reported that

The correlation between gold and the 10-year Treasury has jumped above 0.6 at some points over the past five years and has fallen below minus-0.8 during others, changing direction several times.

It is important to understand that correlation is more than just the CORREL function in Excel. As Ray Dalio says,

People think that a thing called correlation exists. That’s wrong. What is really happening is that each market is behaving logically based on its own determinants, and as the nature of those determinants changes, what we call correlation changes. For example, when economic growth expectations are volatile, stocks and bonds will be negatively correlated… However in an environment where inflation expectations are volatile, stocks and bonds will be positively correlated.

My biggest problem with relying on correlation is that it is likely to fail you. Worse, it is likely to fail you just when you need it most. For example, during the 2008 crisis, several traditionally uncorrelated assets became highly correlated, as investors were forced to liquidate similar portfolios. Things that were previously non-correlated have an unfortunate habit of losing their non-correlation just when you need it most i.e. in periods of extreme distress and risk. Thus, to rely on non-correlation as a core part of your trading strategy strikes me as asking for trouble.

I try to structure my portfolio so that I can benefit from non-correlation, but am not dependent on it.  I try to add non-correlated trades into the portfolio, and try to avoid adding trades that are likely to be highly correlated with my existing positions. However, I never add a trade because it is non-correlated: to do so would be inviting danger.

Relying on non-correlation is like the banker who will only lend you umbrellas when it is not raining: everything looks fine until you need it. Try to include non-correlated assets in your portfolio, but you should also manage risk at a portfolio level. Stress-test your portfolio to see what happens if everything becomes perfectly correlated, and have a plan to respond if that happens.  To quote Taleb:

Anything that relies on correlation is charlatanism.

Finally, please indulge me a personal note. You will be pleased to hear that I achieved one of my great life ambitions today: I have finally won as many Tour de France titles as Lance Armstrong.

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  1. Tuesday links: impermanent validity - Abnormal Returns | Abnormal Returns

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