Historical Correlation Among Asset Classes

For a recent five-year period, __correlations between major asset classes__ were calculated as shown below. | # | Asset Class | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | |---|---------------------------|-------|------|------|------|------|------|------|---| | 1 | Bonds | 1.00 | | | | | | | | | 2 | Commodities | 0.01 | 1.00 | | | | | | | | 3 | International Stocks | 0.05 | 0.69 | 1.00 | | | | | | | 4 | Emerging Market stocks | 0.11 | 0.72 | 0.88 | 1.00 | | | | | | 5 | US Small Company Stocks | -0.15 | 0.56 | 0.83 | 0.78 | 1.00 | | | | | 6 | US Large Company Stocks | -0.03 | 0.65 | 0.90 | 0.81 | 0.94 | 1.00 | | | | 7 | Cash | 0.07 | 0.21 | 0.11 | 0.26 | 0.05 | 0.04 | 1.00 | | | 8 | Gold | 0.27 | 0.51 | 0.12 | 0.26 | 0.05 | 0.08 | 0.08 | 1.00 | According to the table, what is the five-year correlation between Commodities and US Small Company Stocks?

As a further test of correlation, which two assets present the greatest potential for diversification benefits when combined in a portfolio?

No, that's the correlation between commodities and bonds. Note the intersection between commodities (Asset #2) and bonds (Asset #1).

No, this is listed along the diagonal of the chart simply because every asset's correlation with itself is 1.0.

No, while a correlation of 0.01 is impressively low, there is an even better combination.

No, this correlation is 0.88, and the highest of any two assets on the table. You should be looking for low correlations.

Exactly! The correlation of -0.15 is the lowest on the table, which indicates the most powerful combination for diversification benefits.

However, even what seems like a fairly large correlation can still be useful in a portfolio. Consider the correlation between US large company stocks and commodities. There is a positive correlation over the five-year period of 0.65 as shown. Now suppose that the standard deviation of US large company stock returns is measured at 20%, and the standard deviation of commodities is also measured as 20%. An investor shifts from 100% US large company stocks to 50% US large company stocks and 50% commodities. What is the expected standard deviation of returns for this portfolio?

No, this would be the case only if the two asset classes are perfectly correlated (r = 1). But this is not the correlation between these two asset classes.

No, the portfolio couldn't be risker than a 20% standard deviation in this case, since the two asset classes which make up the portfolio each have a standard deviation of 20%. That's the maximum risk possible.

To summarize: [[summary]]

Yes! Since the correlation between these two asset classes is 0.65, and therefore less than 1.00, putting them together provides some diversification benefits, lowering the standard deviation of the portfolio below 20%.

Correct! This is the intersection in the table between commodities (#2, so column 2) and US Small Company Stocks (#5, so row 5).

0.56

0.01

1.00

Bonds and Commodities

International Stocks and Emerging Market Stocks

Bonds and US Small Company Stocks

20%

More than 20%

Less than 20%

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