29 November 2024

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Correlation

Luigi Campopiano

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In financial markets, the butterfly effect is not uncommon—a phenomenon where small changes in conditions can lead to significant long-term variations in a system's behavior. According to Carmignac, “an increase or decrease in the value of one asset can have direct and significant consequences on other seemingly unrelated assets. Understanding this phenomenon, known as correlation, becomes crucial when building an investment strategy.”

Correlation measures how securities or asset classes move relative to each other:

• Highly correlated investments tend to rise or fall together.
• Low correlation investments behave differently under various market conditions, enabling investors to diversify returns.

Carmignac experts explain, “To identify different types of correlation, it’s useful to start with practical examples observed daily in financial markets. For instance, when oil prices rise, airline stock prices tend to drop. This happens because higher jet fuel prices increase operating costs for airlines, negatively impacting profitability and stock prices. This is an example of negative correlation.

Another classic example is the effect of currency price changes on exporters’ stock valuations. A depreciation of the euro against the US dollar positively impacts European companies exporting to the US but increases export costs for American companies selling in Europe. The same movement can thus result in positive or negative correlation.”

To reduce exposure to specific risks of a particular asset class and contain portfolio volatility, investors can diversify their holdings by combining uncorrelated assets. Carmignac highlights, “This strategy helps mitigate certain risks and potentially delivers more stable and consistent performance. For instance, corporate equities can be combined with government bonds, as these two asset classes are considered to have low or even negative correlation, as evidenced over the last 20 years.”

However, the correlation or decorrelation between two or more asset classes is not permanent; it can change over time. It is important to regularly analyze and identify the factors driving these changes. Carmignac adds, “Between 2000 and 2020, bonds and equities typically showed opposing trends, counterbalancing each other and acting as shock absorbers. During equity market downturns, bonds helped mitigate capital loss risks for investors. However, in 2022, both equities and bonds experienced simultaneous shocks. The two main asset classes that shape market activity moved in the same direction due to the inflationary wave.”

To build prudent portfolio management, it is essential to conduct a thorough analysis of available instruments and their correlation. This ensures effective diversification, protecting the portfolio from potential market turbulence while allowing it to take advantage of opportunities across various market segments.