On November 13, 2019, Julie Brough, Executive Vice President & Portfolio Manager at Logan Wealth Management, hosted a webinar covering the fundamentals of how volatility and correlation affect your financial portfolio. This presentation was entitled: Volatility and Correlation: How they Impact your Investment Success.
PART 2 OF 2
The importance of correlation. What does diversification really mean? Why do we need to understand the underlying drivers of a business or security? How do we deal with non-investment grade bonds? What are the limitations of correlation?
Why is correlation important? Correlation is a measure of the degree to which two securities move in relation to each other. (See Blog 1 of this webinar for more detail.) Correlation is the reason why we diversify portfolios.
What does diversification really mean? Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. (Source: Investopedia.com)
We take this further by breaking asset classes down into industry sectors and look to diversify among different types of industries.
Figure 1
TD Bank and Royal Bank are highly correlated. They pretty much move in tandem with each other. This makes sense because they are both in the financial services industry.
Figure 2
Finning, a Caterpillar dealership based in Western Canada, and Royal Bank have low correlation. This is to be expected since they are in different industry categories – industrial equipment and financial services, respectively.
Figure 3
Understanding the underlying drivers of a business or security
Beyond diversifying among different industries, we need to understand if there are any correlations between assets in different industry categories.
Correlations can exist even where we don’t expect them to. For example, Canadian Western Bank, which operates primarily in western Canada, is very highly correlated with Finning, even though they are in different industries.
Figure 4
You need to know what the underlying drivers of the business or the security are, i.e. what they are tied to beyond what industry they are in. Canadian Western Bank lends to energy companies and employees of energy companies. Finning sells equipment to companies in the energy sector. Both of these companies’ success is dependent on the success of the energy sector.
Non-investment grade bonds
Non-investment grade bonds, formerly known as junk bonds, are lower quality bonds. While bond prices are normally based on interest rate movements, lower quality bonds are priced based on credit quality since their risk is related to repayment. The issues that impact repayment of non-investment grade bonds are more closely related to stock price than to interest rates, so they move in tandem with stocks, not with other bonds.
If you don’t take this into account and you treat non-investment grade bonds as regular bonds, you disregard the correlation between them. But, because we recognize the high correlation between non-investment grade bonds and stocks, we actually treat them not as bonds but as stocks so we don’t miss this correlation.
What are the limits of correlation?
Nothing works perfectly all the time and the limits of correlation become especially evident when there is a downturn in the market. When that happens and panic sets in, there is a tendency to eschew logical thinking and just sell. This results in an increase in correlations.
Correlations are usually measured mathematically as anywhere between minus one to one, with minus one meaning movement in exact opposition to each other, and one meaning perfect correlation. Hence the meaning behind the industry expression, “In a crisis, correlations go to 1”.
As we see exchange traded funds and indexing drive higher trading volumes, there will likely be an increase in correlations because these securities are bought and sold in baskets. This makes sense because if the same securities are always grouped together in a basket and there are higher trading volumes, the correlations between securities in that basket will rise over time. This will make it more difficult to get full diversification across a portfolio in the future.
Key takeaways regarding correlation and overall conclusions of the webinar
It’s important to control the volatility in a portfolio. You need to make sure you won’t have price swings greater than what your financial wherewithal can absorb. The higher your volatility, the higher the impact path risk will have on your portfolio. Conversely, reducing volatility reduces the chance of failure due to path risk.
A well diversified portfolio that has low correlation among holdings reduces the impact an extreme downturn event will have on it. This is important because we know how difficult it can be to recover from such a downturn, especially if you are already in the withdrawal stage.
To put it another way, a highly correlated portfolio has higher volatility and decreases your chances of success in reaching your investment goals.
So, once again, plan for the worst and hope for the best.
Disclaimer: Please note that the information presented here is intended as general information only. It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as investment advice. Please consult your adviser to determine whether this information is applicable to your personal situation.
