Using correlations in asset allocation


September 2011. Correlation tables have their limitations, and an understanding of these is important to avoid investment errors. This paper looks at two aspects of correlation tables that, in conversations with clients, have caused the most misunderstanding. 

 

First, the choices of data frequency and of the time period used when calculating a correlation are both subjective decisions that carry with them potential hazards.

 

Second, stronger correlations among assets exist in bear markets than in bull markets, which is precisely opposite to the needs of investors. Combine this with the observation, from behavioural economics, that investors dislike losses more than they like gains of the same magnitude, and it is clear that some form of bias in the calculation of the correlation data may be appropriate to compensate for these two asymmetries.

 

The overriding message is to use correlations carefully. Understand the methodology used, know the volatility of a correlation as well as its value at any one time, and perhaps assume a stronger correlation than that produced by the maths to take into account certain asymmetries. (Read more)

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