Sunday, 15 July 2012

Stumbling around correlations

Correlations are misleading.

I make that statement from personal experience, since I never had to grapple with such concepts while I was studying the methods of systemic functional linguistics and feminist discourse. And while it’s given me a firm background in writing for readability, it’s not particularly useful for any grounding in numbers.
So everything henceforth is the spewage of an untrained mind. You have been warned.

Typically, this is what a correlation matrix looks like:

 Correlation Matrix, end-2001 to end-2011
MXWD Index
JP Morgan Global Aggregate Bond Index
S&P Gbl Property TR Index (US)
MXWD Index

JP Morgan Global Aggregate Bond Index

S&P Gbl Property TR Index (US)

ThompsonReuters/Jefferies Commodity CRB Index

Correlation goes to two extremes of 1 or -1, and 0. And over 10-year data, the relationships do hold quite well. That was until I came across this post on intermarket analysis at Tuckerreport, which in a nutshell says there is no stable correlation between the movements of various markets on a daily basis. This is all good, because from the point of view of trading, you’re talking about short-term bets that are unlikely to hold for more than a week, so even if you had a strong correlation between two markets, on its own, it does little to determine which direction of a trade to take, or generating buy/sell signals.

From a long-term investor’s point of view though, does correlation add any value to building a diversified portfolio? I’m defining a diversified portfolio as a portfolio consisting of two or more weakly-correlated assets.

Tracking That Tucker
A picture tells a thousand words, so using the CORREL function in excel, I pulled rolling 1-year correlation between equities and bonds.

Correlation runs from +1 to -1. Put crudely, it’s the how two random variables move together. If the correlation of two numbers approaches 1, they move together, for instance, as age increases, so does height. If the correlation approaches -1, they move apart, for instance, the amount of air that escapes a balloon increases as the size of the balloon decreases. A low correlation of around 0 implies there is no strong relationship between two variables, i.e. independent relationship, like your age and how many bowls of laksa you eat a week. For diversification purposes, I’m looking for assets that hold low correlation.

Chart1: Equity versus bonds

The traditional equity-bond mix actually has seen periods of high-correlation, somewhat contrary to conventional wisdom. Does this mean the weak correlation between equity and bonds is a myth? 

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