Did I lose you yet? Do you know what that is? This is how we are able to relate one investment to another, it is called Correlation. This is a single number that describes the relationship between two “variables.” These “variables” are what we call asset classes in the investment world. We use 19 different asset classes in our portfolio, but for an example I will discuss large company stocks in relation to very short term bonds. These two asset classes should be a good representation of investment relationships. Why is that? This is due to the fact that stocks have a very wide range of price movement whereas short term bonds have very little price movements.
If we were to relate the S&P 500 to it self, this would give us a correlation of 1. The correlation between the S&P 500 and the short term bond is 0.034, which tells us that there is very little relationship between the two investments. If the number is negative that would mean that the prices tend to move in the complete opposite direction most of the time. This is just one step in the creation of a portfolio. As you can imagine, when you integrate 19 different asset classes in a portfolio there is much more information you have to look at than just returns. We need to understand how investments work in relationship to each other in order to create a portfolio that is in line with your investment temperament.
Philip A. Guske