In our ongoing effort to clarify and simplify, we keep the financial jargon to a minimum. But even where we may succeed, you’re likely to encounter references elsewhere that can turn valuable information into mumbo-jumbo. Consider us your interpreter. Today, we’ll explore correlation, and why it matters to investing.

A Quick Take: Correlation Helps People Invest More Efficiently

Expressed as a number between –1.0 and +1.0, correlation quantifies whether, and by how much two holdings have behaved differently or alike in various markets. If we can identify holdings with weak or no expected correlation among one another, we can combine these diverse “pieces” (individual investments) into a greater “whole” (an investment portfolio), to help investors better weather the market’s many moods.

Correlation, Defined

As suggested above, correlation is more than just a quality; it’s also a quantity – a measurement – offering two important insights along a spectrum of possibilities between –1.0 and +1.0:

1. Correlation can be positive or negative, which tells us whether two correlated subjects are behaving similar to or opposite of one another.
2. Correlation can be strong or weak (or high/low), which tells us how powerful the similar or opposite behavior has been.

Correlation, Applied

Most investors are aware of the benefits of diversification, or owning many, as well as many different kinds of holdings. A well-diversified portfolio helps you invest more efficiently and effectively over time. Diversification also offers a smoother ride, which helps you better stay on course toward your personal financial goals.

But in a world of nearly infinite possibilities, how do we:

• Compare existing funds – If one fund is expected to perform a certain way according to its averages, and another fund is supposed to perform differently according to its own averages, how do you know if they’re really performing differently as expected?
• Compare new factors – What about when a researcher claims they’ve found a new factor, or source of expected returns? As this University of Chicago paper explains, “factors are being discovered almost as quickly as they can be packaged and sold to the waiting public.” How do we determine which are actually worth considering out of the hundreds proposed?
• Compare one portfolio to another – Even perfectly good factors don’t always fit well together. You want factors that are not only strong on their own, but that are expected to create the strongest possible total portfolio once they’re combined.

Correlation is the answer to these and other portfolio analysis challenges. By quantifying and comparing the behaviors and relationships found among various funds, factors and portfolios, we can better determine which combinations are expected to produce optimal outcomes over time.

Correlation, Concluded  

Heeding correlation data is a lot like having a full line-up on your favorite sports team. If each player on the roster adds a distinct, useful and well-played talent to the mix, odds are, your team will go far. Similarly, your investment portfolio is best built from a global “team” of distinct factors, or sources of returns. A winning approach combines quality components that exhibit weak or no correlation among or between them across varied, long-term market conditions.

Let us know if we can use our experience and expertise to help you build a more diversified and less correlated portfolio.

Before you do business with an advisor or fund manager, it can be telling to ask this powerful question: How do you invest your money? At Hill Investment Group, we believe in our approach to the core. We take for granted that our stance is rare in financial services, where most advisors invest one way for themselves and another for their clients.

Why don’t they eat their own cooking? Their precise portfolio allocations might vary based on individual goals and risk tolerances. But if your advisor is not investing the bulk of their personal assets according to the same strategy and within the same investments they’ve recommended to you … why not?

At Hill Investment Group, our own money makes up about 11 percent of the total assets we manage as a firm; and we use the same fund families, portfolio builds, and evidence-based investment approach we recommend to our clients. When we’re advising a client to stay the course during a down market or to avoid chasing a hot trend, we’re doing the same thing with our personal assets. We feel the same fluctuations, and stay the same course toward the same expected returns. Alignment in this way feels right to us.

As much as all of us at Hill Investment Group feel like family to one another, there are times when our actual family members must come first. On that note, it is with regret but considerable affection that we wish Dyanna Jones well as she leaves the HIG team to dedicate more time to her family.

Dyanna asked us to let you know she will miss everyone here at HIG, especially the many friends she quickly made among our Houston office clients and guests. If you would like to convey your own best wishes to Dyanna, please let me know, and I will be sure to pass them on.

While it will difficult to replace Dyanna’s warmth, we are now seeking a new executive assistant for our Houston office. If you know of anyone who might be a good fit for the role, we welcome your referral.