Understanding Correlated Vs. Non-Correlated Assets
Investors are always looking for an excellent hedge against their position in the market. Finding the right opportunity can be a challenge, however, given how important the markets are to overall financial trends. Diversifying your portfolio through stocks, funds, and bonds is often not enough: in fact, each of these three financial options come with their own correlations to market moves that may run in opposition to what you want them to do as a hedge.
That’s where asset correlation makes a big difference. Many alternative investments enjoy a low correlation with the stock market, which can make them an attractive hedge against certain market conditions you may not want to experience. That’s because they enjoy several characteristics that may make them move in different directions than the stock market, thus helping your portfolio be less tied to market swings.
Not all alternatives provide the same kind of hedging factor, given that their correlation to the markets vary. This means you need to know a bit more about correlated vs. non-correlated assets before diving into alternatives as a market hedge.
What Asset Correlation Means
Asset correlation measures how one asset moves in tandem with another. For example, the S&P 500 often moves in tandem with bond markets: when the stock market does well, bonds swoon. When the market drops, investors flock to bonds for refuge. This is because certain investments share a high or low correlation with one another.
Investors looking for a hedge against a market downturn would therefore seek out investment opportunities with low correlation to the stock market. The value of these assets would, mathematically speaking, be less likely to drop in value when the market does. The less correlation these kinds of investments have with one another, the better they are at resisting changes in value based on the fluctuation of one another.
There are mathematical formulas for determining asset correlation. The most common is the following:
- ρxy represents the correlation between two variables—in this case, two asset classes
- Cov(rx, ry) represents the covariance of return X and covariance of return of Y. In this case, covariance refers to the degree to which two kinds of asset classes might overlap in terms of returns
- σx represents the standard deviation of X. In this case, this standard deviation determines how much an asset's value stretches from the mean (i.e. if you can expect a similar return most of the time). The lower the number, the more likely you are to get the same return repeatedly with a lower range of possible outcomes. σy represents the same, only for the other investment you’re considering
When you use this formula to measure correlation, there are three potential outcomes:
- Positive correlation: when two variables typically move in the same direction (such as a person’s height and weight)
- Negative correlation: when two variables move in opposite directions (such as the idea of scarcity vs price)
- No correlation: when two variables do not move in relationship to one another
The difference between correlated vs non-correlated assets signals how closely tied a certain investment is to the ebbs and flows of the stock market. A high correlation means a non-market asset is likely to move in the same direction as another. Low correlation means the opposite: the two assets move independent of each other. No correlation suggests that the two kinds of assets have no effect on one another, which can be an important consideration as far as how you build your portfolio.
The Importance of Low- and Non-Correlated Assets
High-correlation assets might increase in value together, but when one drops the other does too. Negative correlation assets, although tantalizing, can wreak their own havoc on your portfolio, as you wouldn’t want one asset class to tank whenever another rose. Rather, you’re better off selecting assets that have little effect on one another in the first place.
Assets with low or no correlation provide you with just that. The less two or three kinds of assets correlate, the less likely you are to suffer significant setbacks when one element of your portfolio loses value. For example, if the stock market takes a nosedive, you wouldn’t want your other portfolio holdings to follow suit. If you include assets with low correlation or no correlation to the stock market, you’re less likely to see the market trend impact these other parts of your overall asset mix.
Mind you, there are different shades of gray when it comes to asset correlation. Most assets will correlate to a certain degree with one another, so you’re not making binary choices here. Rather, the objective for hedging or diversifying is to pick assets and asset classes with different degrees of correlation. Some amount of correlation can be a good thing, depending on what role you want the underlying holding to play in your strategy. But for hedging purposes, the less correlation, the better.
Examples of Assets with Low or No Market Correlation
If your entire portfolio consists of stocks, funds, and bonds, you might be running the risk that your holdings correlate too closely with one another. If markets drop, bond activity may increase, which isn’t necessarily ideal when you’ve got a 60-40 portfolio in place. Likewise, when stocks dip, most investment funds may drop in value as well (notwithstanding volatility index funds, which purposely increase in value when the stock market dips).
Some alternative investments, such as farmland investing, enjoy low correlation with market trends. In fact, data suggest that farmland value has not moved in tandem with the Dow Jones Industrial Index—particularly when the index loses value or during recessionary periods.
Every asset type has a different correlation with one another, mathematically speaking. But for our purposes, let’s stick to the stock market and bonds as our point of comparison for asset correlation. Here’s how several common investment types correlate to the stock and bond markets:
Sources: Farmland Values: NCREIF Farmland Index, Timberland Values: NCREIF Timberland Index, Real Estate Values: NCREIF Property Index, Stocks Values: S&P 500 Index, Bonds Values: Bloomberg Barclays US Aggregate Bond Index
Asset correlation ranges from 1 as the highest amount of correlation and -1 being the lowest. As mentioned above, both positive and negative correlation can have a deleterious effect on your portfolio. If you’re looking for low-correlation assets, your ideal correlation figure is as close to 0 as possible. Most low-correlation assets will hover somewhere near zero without actually hitting it straight on. These variances, as minute as they may seem, can make a big difference still. That U.S. stocks and bonds only correlate by 0.06 still means that they trend in the same direction less than U.S. bonds do with U.S. real estate investment trusts (or REITS).
The devil with regard to asset correlation truly does live within the details. Unless you specifically want two investment types to share a negative or positive correlation, you’re likely looking for assets as close to zero as possible with one another. A fraction of a percent signals how close the two move together or apart, even if the correlation itself might seem small. After all, we’re talking about these percentage points at scale, which can translate into thousands of dollars of growth or loss at stake.
As you can see from the above, farmland has a negative correlation factor -0.05, meaning it increases slightly when stocks decrease in value. This makes it a great hedge against market trends: your farmland investment may not, mathematically speaking, move up or down when the stock market does. This is compared to other investment types, such as real estate and U.S. treasury bonds, which move much more in line with the ebb and flow of the stock exchange.
Alternatives tend to enjoy lower correlation with publicly traded equities, partially because their intrinsic value isn’t reliant on market moves to determine its worth. This is true for real assets, such as real estate or farmland, which rely on other factors to determine their worth. It’s also true to a lesser extent for alternatives like cryptocurrency—at least so far in their nascent stages.
Seeking No-Correlation Assets with FarmTogether
The more you include low-correlation assets, the more diverse your portfolio can truly be. You’ll want some portion of your investments to prosper without correlating to other market moves. This can help you lock in a certain amount of value when other parts of your portfolio falter, or can expose you to outliers that might increase in value without much notice.
Farmland investing creates a unique value proposition in this way. The value of the underlying farmland has increased on average per decade since the 1990s. That means its value has weathered financial storms in other sectors while remaining relatively unscathed. This is just one example of its hedging power as well as its overall importance in a well-balanced portfolio.
When you invest in farmland with FarmTogether, you’re adding a low-correlation asset into your portfolio with a track record of sustained value as well as one that provides a strong inflationary hedge.
Disclaimer: FarmTogether is not a registered broker-dealer, investment adviser or investment manager. FarmTogether does not provide tax, legal or investment advice. This material has been prepared for informational and educational purposes only. You should consult your own tax, legal and investment advisors before engaging in any transaction.