It is well known that an efficient portfolio should be comprised of uncorrelated assets. The objective is to cover possible widespread falls of all portfolio assets. But what is the negative effect of investing in correlated assets? Does the correlation benefit at any point? How often does the correlation work against the earnings?
Firstly, we focus on S&P500 in order to test if the years with more correlation are related to the years with less performance. We split its performance annually, and we calculate the correlation between its components each year. In general, there’s a fairly clear negative relationship between correlation and performance. That is, down trends’ correlation is high. When the return of one stock is negative, the remaining assets comprising the index will fall as well; this will make it difficult to earn if while investing in highly correlated stocks.
In spite of the negative relationship, in some years (such as 2009), the index performs much like other years, even though the correlation is one of the highest.
What happens if we create a portfolio comprised of some of these S&P500 stocks? We can answer this question by creating a portfolio with a successful strategy between 1997 and 2015. Every week we select 25 assets from the 500 stocks comprising the index.
The stocks are going to be as correlated as they were in the index (because they are the same assets). But are we investing in the most correlated stocks? And if this is the case, does the high correlation work against performance?
There’s a negative relationship between correlation and performance again. The higher the correlation, the more poor the performance.
Although there’s this negative relationship, the strategy outperforms the index when the assets are high correlated.
Although you should pay attention to the correlation between the stocks in your portfolio because it could go against you in down trends, with an effective strategy, you could reduce this damage. So, keep in mind the correlation to invest, although it’s be better when based on a good investing strategy.