Asset class correlations determine how investment categories respond to the same events. High correlations can be risky, and diversification is key to minimizing risk and maximizing profit. Allocating money to different types of securities within the same asset class can achieve diversification. Commodities and stocks within the same sector may be uncorrelated, providing further diversification opportunities.
Asset class correlations represent the probability that investment categories will respond in a similar way to the same event or conditions. When investors tend to treat a pair of asset classes in the same way, these groups are said to be highly correlated. Conversely, investment categories are considered to be uncorrelated when the same type of market or economic conditions trigger different responses in each group. Investors often incorporate uncorrelated asset classes into a portfolio to provide the greatest protection against risk and opportunity for profit.
When asset class correlations are high, it could be dangerous for an investor to limit exposure to these categories. If two groups have a history of moving together, it can certainly be profitable when the markets are strong. However, financial markets tend to move in cycles, and over time, any upward momentum is likely to wane or even reverse. As a result, investors who are constrained to high asset class correlations will likely experience similar losses in a low-resource portfolio.
In general, asset class correlations are valid under all rational market conditions. However, there is not always a reasonable explanation of the direction in which financial securities are traded; sometimes they deviate from traditional business norms. This can wreak havoc on an investor’s portfolio when an individual or institution is trying to diversify exposure to minimize risk and generate the best possible returns. When trading is especially unpredictable, market experts may recommend that investors hold onto their cash to avoid extreme conditions that may be erasing asset class correlations.
Investors could achieve diversification by allocating money to the same asset class but in different types of securities. For example, there are corporations that participate in specific sectors, such as energy or metals. An investor could invest in the capital of these businesses by buying shares.
There may be little asset class correlation with financial values that represent real natural resources or commodities that comprise energy and metals. For example, natural resources and commodities are generally traded as commodities, which is an investment category that has little correlation to stocks. As a result, investors could buy commodities and stocks that are linked to the same sector, but are not correlated. While these asset classes may respond to each other, they may also be uncorrelated. Different factors could move commodity markets compared to equity investment sensitivities.
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