Asset Correlation

What is asset correlation?

Generally, it describes how much two different assets move in the same or opposite direction. There's an actual calculation that can be made to find the correlation and that number is between -1 and 1. Basically, if the correlation is 1 between two assets, then they always moved up and down together. If it is -1, then they always moved in opposite directions. If the correlation is 0, then they neither always moved together nor always moved in opposite directions.

How can I use the knowledge of correlations to my advantage?

Historically, stocks and bonds -- the two most common investment assets -- are barely correlated with a correlation of a little over 0. Over short periods of time that correlation can go negative or more positive, but that doesn't matter because you can't reliably predict the changes. Basically, they sometimes move together and sometimes they don't. As a result, setting a smart asset allocation with stocks and bonds will create a portfolio where the wild swings of one asset can be tempered by the other. Therefore, your overall portfolio value will be more steady. This is precisely why many people use stocks and bonds together.

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