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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 JONNELLE MARTE

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

Journal Reports
in relation to one another. For instance, it's
Read the complete Quarterly Investing in
Funds report . widely considered good practice to reduce
volatility in your portfolio by investing in a
S&P 500 Correlations
variety of assets whose values 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
View Interactive
clients. At a time when many assets are
Diversifying a stock portfolio requires experiencing unusually high correlation—a trend
investments that don't move in lock-step. See that has pummeled some portfolios—it's a topic
how various indexes would have correlated to worth grasping.
moves in the S&P 500.
More photos and interactive graphics "It has become more important over the years,
because the world is more interconnected, for
people to 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:

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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
David Plunkert in opposite directions at a scale that doesn't
vary.

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.

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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.

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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