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  • Martyn Johnson

Correlation

This article is about how investments get on with each other - and why sometimes we don’t want them to.


Market Commentary

The USA continues to pay its bills. UK House prices falling. Federal Reserve raises interest rates to highest level in over 20 years, but future rises likely to slow. China into deflation. July hottest month on record (globally not here in blighty).


Correlation Effect

A client called me a few years ago – I will call him Fred – we handled his main investments, but he had a few shares he bought and sold himself as a bit of a hobby. Fred rang me because he had identified a particular stock which looked very good on paper - the stock had averaged just under 10% p.a. in returns over seven years. I said thanks for letting me know, that I would update my records and (quickly) tried to put down the phone. No chance. Fred then got onto the real reason he was calling – he said that what worried him was that the shares of this company, whilst often having stellar performance, had on the odd occasion suffered significant falls. I suggested he offset the risk by seeking out a second share whose performance contrasted to the first company. There follows the example I gave Fred.


Ice Cream and Umbrellas

The following will help you to understand correlation. If there is an investment we want to recommend to a client but we have concerns about its volatility (risky, goes up and down a lot) – in the example an ice cream manufacturer, whose share price is linked to the weather (profits go up in good summers and fall during wet ones) – and we like the idea of holding this investment but want to tone down the risk a bit then we might buy a second investment where returns move differently. Share values in an umbrella manufacturer might help here since they are also driven by the weather but in a very different way. By combining two investments in this example, we have mitigated the investment risk related to the climate.


This principle can be extended to geographical correlation, currency rate correlation, sector correlation, interest rate correlation etc.


Summary

This stuff ain’t simple – because markets can and do change and major events can override normal investment behaviour e.g. Truss / Kwarteng mini-budget. Our focus as always remains on the medium term and as the only guide we have to the future is the past, we intend to continue in the main with time proven investment techniques using correlation as a tool.


p.s.

Correlation is a measure of the connection between two things. Positive correlation is where stuff moves in the same direction and negative correlation is where it moves opposite directions. Examples of both: my wife is happy, I am happy. Family outing - kids are happy, I am unhappy (I end up paying), Bank holidays and bad weather, interest rates up, house prices down. In the investment world we try to use correlation as a sort of insurance policy.

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