What do you get when you combine an evidence-based process with visionary team spirit and brilliant leadership? A World Series Commissioner’s Trophy, for starters. The “rags to riches” tale of the Houston Astros 2017 World Series victory is now available for your reading pleasure, thanks to Sports Illustrated senior writer Ben Reiter.

We love the recent approach to managing the Astros because it mirrors our approach to investing in two major ways:

• First, it is backed by data. The Astros management seeks to fully understand the factors that drive wins, quantify them, and weight heavily toward them.
• Second, like with investing, achieving your long-term goals may sometimes require short-term sacrifices. If you have the right philosophy and the right process, you can trust that the odds will work in your favor long-term.

Something of a visionary himself, Reiter actually predicted the team’s 2017 victory on the cover of the magazine’s June 30, 2014 edition. Was that luck or forecasting talent? You be the judge, when you read Reiter’s entertaining account in “Astroball: The New Way to Win It All.”

Reminiscent of Michael Lewis’ Moneyball tale of the Oakland A’s, the Astros applied similar evidence-based strategies to improve their game. They leveraged what the Oakland A’s Billy Beane began and took it a step further, incorporating (with help from the “Nerd Cave”) scores for more unconventional qualities, such as personality and grit. These elements and more are touched on in this review: “[R]oster-creation, all by itself, did not bring home the championship. Building an exceptional team is one thing, but making it work as a team is another.”

We’ve said it before; we’ll say it again: We couldn’t be prouder of our exceptional home-town team. Go Astros!

Bonus read: For more of baseball’s rich historical lore, I also enjoyed this recent PBS documentary on legendary hitter Ted Williams, in all his quirky glory (narrated by St. Louis’s own Jon Hamm). This related New York Times piece tells the backstory of how some of the film’s best footage was almost lost for good.

As we described in this related article, we’re fans of taking a rules-based approach to investing instead of trying to actively forecast a market’s next move or a stock price’s next swing. Attempts to outsmart the market are more likely to waste your energy than deliver higher long-term returns.

So, this begs the question: Why don’t we recommend index funds exclusively for our clients?

We really like aspects of the indexing philosophy. Passively managed index funds typically employ a rules-based strategy to capture returns by tracking a popular index at a low cost. So far, so good. But, as we focus in, like we did in this piece, we start to find some inefficiencies that point to why index funds may not be the optimal vehicle for clients looking to maximize market returns. Curious to learn more? Give us a call.

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.