Stock Correlation What Does It mean
You have in always been told never to put all your “eggs in one basket”. These days, your basket a.k.a the stock market 1000’s of options to invest your money. Start to learn how to avoid putting your heard earn money into multiple stocks that are really all together in the same basket.
The approach you are about to learn is called market correlation. The word correlation means a connection between to things. There can be a negative and positive correlation which we explain below.
Market Correlation Explained
A negative correlation happens when one variable increases when other decreases and vice versa. You use this to diversify and have a steadier portfolio.
A positive correlation is when one stock rises another will rise with it. When one of those stocks fall the other one will fall with it.
One of the reasons that diversifying an investment portfolio over many industries helps reduce risk is that individual stock and bond returns do not necessarily move up and down in at the same time.
An example of a negative correlation when the construction industry is down the alcohol industry can still be up. As a matter of fact the alcohol industry at least the lower end of it can out perform during a recession.
I wouldn’t suggest to invest in lumber and real estate. Guess why they are both in housing. Both will rise and fall at the same time. There is way to much positive correlation or in simpler terms to intertwined.
That said don’t invest in exact opposites, an example lets say you invest a S&P 500 index fund. Don’t invest in Rydex Inverse S&P 500 Strategy (RYURX). If you notice its name includes inverse. The inverse goes for its performance if the S&P gains 5% it loses 5% it works perfectly in tandem you will never earn a dollar.
You need it that they all rise albeit at different times and different speeds.
Asset Class Diversification
U.S. stocks and international stocks do not have perfect positive correlation due to having differing business cycles, and to the cycles of currency valuation.
U.S. stocks and treasury bonds usually have low positive correlation.
Precious metals show at times a low positive correlation to the stock market so if the market is up gold will not rise in tandem it may even fall.
One must keep in mind a few caveats when considering the correlation of asset class returns.
Correlation will vary over time so you check every so often how well your portfolio is balanced.
When equity asset classes experience large drops in value, many asset classes tend to grow more positively correlated.
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