We have previously spoken about the benefits of diversification, and we looked at how important they can be for traders’ performance. We also mentioned that correlations between asset classes might affect the level of diversification which a portfolio has exposure to, and hence the benefits which can be enjoyed by a trader. So let us explore this a bit further.
Theoretically speaking, two asset classes will be compared and a calculation known as “Pearson’s Correlation Coefficient” will be used. You can also just compare any two sets of charts and gauge whether assets move in the same direction or not.
A correlation coefficient of +1 will tell us that two assets are moving in unison, and they have a perfect positive correlation. The reason of this kind of movement is that same set of factors are affecting assets in the same way.
If the number falls between 0 and +1 will indicate some positive correlation. Assets have a stronger correlation when the figure is close to +1. For example, you could argue that the share prices of Exxon and Chevron would have a strong correlation as they are both affected by the price in oil.
With a coefficient of 0, this tells us that there is no correlation and prices move absolutely randomly.
From 0 to -1 indicates some sort of negative correlation. So when prices of one asset go up, prices of another one will go down. In general, commodity supply and demand are negatively correlated.
The important thing throughout is to be aware of correlations of different assets that you choose for your portfolio. When the constituent assets of a portfolio have a strong positive correlation, diversification benefits will decrease.