Asset class correlations represent the likelihood that investment categories will respond in a similar manner to the same event or conditions. When investors tend to treat a pair of asset classes the same, these groups are said to be highly correlated. Conversely, investment categories are considered to be non-correlated when the same type of market or economic conditions trigger different responses in each group. Investors often incorporate uncorrelated asset classes into a portfolio to provide the most risk protection and chance for profits.
When asset class correlations are high, it could be dangerous for an investor to limit exposure to these categories. If two groups have a history of moving in tandem with one another, it can certainly payoff when the markets are strong. The financial markets tend to move in cycles, however, and eventually an upward momentum is likely to slow or even be reversed. As a result, investors who are limited to high asset class correlations are likely to similarly experience losses in a portfolio with little recourse.
Generally, asset class correlations hold true throughout rational market conditions. There is not, however, always a reasonable explanation for the direction in which financial securities are trading; sometimes they deviate from traditional trading norms. This can wreak havoc on an investors portfolio when a person or institution is attempting to diversify exposure to minimize risk and generate the best possible returns. When trading is especially unpredictable, market experts might recommend that investors hold onto their cash to avoid the extreme conditions that may be blurring asset class correlations.
Investors could achieve diversification by allocating money to the same asset class but in different types of securities. For instance, there are corporations that participate in specific sectors, such as energy or metals. An investor could invest in the equity of these businesses by purchasing stocks.
There might be little asset class correlation with the financial securities that represent the actual natural resources or raw materials that comprise energy and metals. For instance, natural resources and raw materials generally trade as commodities, which is an investment category that has little correlation to stocks. As a result, investors could purchase both commodities and equities tied to the same sector but that remain non-correlated. While it is possible for these asset classes to respond to one another, they could also be non-correlated. Different factors could move the commodity markets in comparison to the sensitivities of equity investments.