UNDERSTANDING INVESTMENT CORRELATION

My family loves theme parks. We have learned to travel prepared so we have a special backpack that I carry, that has within several items that might be useful throughout the day. I have rain ponchos, sun screen, spare phone batteries, chapstick, sweatshirts, socks, bandages and Tylenol. You never know which of the above you might need, but you can be certain that eventually you will need them all.
 
In financial terms, we would call the items in my theme park backpack “uncorrelated,” meaning they would be useful under different circumstances from the others. For example, it is not likely that I will need both sunscreen and rain gear on the same day. I also rarely need sweatshirts in sunny California. Some days I try to convince Launa that there is no chance of rain so maybe just this once we should leave the heavy ponchos and sweatshirts behind. As always, her better wisdom prevails and I carry my load dutifully.
 
When people assemble an investment portfolio, they are really just creating a financial backpack. They put in it things they believe they will need in order to achieve success. It is natural to want to include investments that always make money, all of the time. If an otherwise valuable item, like a rain poncho, doesn’t fit the financial forecast for a sunny day, they have a tendency to want to leave it out. Though I can totally relate to not wanting to carry a poncho on a sunny day, I have learned the value of having it with me. When the rain does come, I am always thankful for the many sunny days when I carried that poncho.
 
So how do you know if your portfolio is prepared for the rain? How do you know if it is dangerously overly correlated? The hard answer is, if everything in your portfolio is making good money for you right now, then you very likely have a highly correlated portfolio. This means that all your investments respond in a similar fashion to the same conditions, and you may be at risk if the financial weather changes. It may be counterintuitive to think that having things in your portfolio that are not doing well today could actually be good, but it is the same principle as carrying a sweatshirt in your pack on a sunny day.
 
On one beautiful sunny day Launa and I were enjoying our walk in a crowded theme park when an unexpected cold front came through. As the crowds scurried for the exits we donned our sweatshirts and ponchos and continued to enjoy a much less crowded, beautiful walk.
 
There is great value in having uncorrelated items in your financial backpack. There is wisdom in taking advantage of the sun while carrying the extra weight of a sweatshirt and rain poncho just in case. Take it from a theme park expert. You will absolutely experience both rain and sun in your investing life. Make sure you are always prepared for both.