By Scott Reed
I have been thinking a lot lately about correlation, or the lack thereof. Correlation is a very important part of how I invest.
When I create a portfolio of investments for a client the first thing I do is pick the different asset classes that I want to use. Examples of asset classes would be U.S. stocks, foreign stocks, U.S. bonds, foreign bonds, real estate, etc. And when I create these portfolios of asset classes, one of my main goals is to find asset classes that are non-correlating because non-correlating asset classes are good for each other and they are good for my clients.
Even as I write this I am aware of how boring this subject must sound to the reader. That’s the problem with much of investment philosophy: It’s pretty boring.
But that doesn’t mean that it lacks importance. Understanding the idea of non-correlating asset classes and how they work to benefit your long term investment goals is the equivalent of understanding the technique of chewing and how beneficial it is to eating.
As many of you are aware, I spend a lot of time thinking of different analogies that I can use to explain the investment process.
Last week I found one for non-correlating assets while I was paying my bills. I was recording my payments for my water and light bill and my gas bill. Both are set up to draft because I want to make sure I get those two paid on time every month. It occurred to me that my gas services and my water and light services are pretty good examples of non-correlating assets.
Every year I spend about the same amount of money on both services. However, there is a big difference in how much I spend on water and light during the summer and the winter. During the summer my water and light bill is enormous. During the winter months it is hardly worth noticing.
The opposite is true for my gas bill. It soars during the winter months and in July it was less than $25. What is interesting is that if you add the two bills together each month, I pay pretty much the same amount each month. As one decreases, the other increases. When one is at its lowest, the other is at its highest. The nice thing about that occurrence is when you put the two bills together it is easy to plan for those expenses. It’s always about the same.
This is an example of negative correlation as opposed to non-correlation. Negative correlation is very hard to find in the investing world, but hopefully you get the picture. One of the biggest challenges for investors is not that their investments will fluctuate; it is that they might be down when the investor needs their money.
So if you can find two investments that are both expected to have an 8 percent return per year for the next 10 years and have a negative correlation, that means that when one of the investments is up, the other should be down. Even though there may not be a single year that either of your investments is up exactly 8 percent, when you put them together you should come much closer to that 8 percent mark than by using either one of the investments on its own.
If you take that one step further, it means that if you end up needing your money in five years instead of 10, there is much less of a chance that your investments will be in a place that makes it unwise for you to take your money out of your investments. Less correlation means a smoother ride and a smoother ride means that you are more likely to be able to use your money when you want it or need it. And that is a good thing.
I spend a great deal of time trying to find the equivalent of my water and light bill and my gas bill in the investment world. It is one of the biggest factors in allowing my clients to use their investments to better their lives. Because when it is time to pay for college or put a down payment on a house, you need to be able to use your money. You may not have time to wait for your portfolio to turn around.
Scott Reed, CIMA, AIFA, is CEO of Hardy Reed Capital Advisors in Tupelo.