Asset Correlations in Action

In causation, the results are predictable and certain while in correlation, the results are not visible or certain but there is a possibility that something will happen. Causation is an action or occurrence that can cause another. The action does not always result to another action or occurrence but you can see that there is a relationship between them. But for the most part though, in the absence of unique situations, the share prices of major oil companies generally move together up or down.

Comparative Performance

Option two is the Fine Art Fund; a mutual fund made up of fine art investments. If they both have the same risk-return profile, does it really matter which one you select? In many ways, Exxon and Chevron are the same company. They are in the same industries, operate in similar countries, and are affected by the changing price of oil and related commodities. One should expect their share prices to mirror each other to a great degree. In , faulty equipment, human error, and fatigued crew were factors in the crash of the Exxon Valdez in Alaska.

A crash that caused many problems for Exxon. In Ecuador and other jurisdictions , Chevron is involved with the Ecuadorean government and others over environmental issues that may result in fines and costs to Chevron. But for the most part though, in the absence of unique situations, the share prices of major oil companies generally move together up or down. That is why I would anticipate the correlation between Exxon and Chevron being close to 1.

I would expect over a long period for the two companies to track each other quite well in share price. XOM and Chevron stock symbol: But although they are close, they are not exact matches.

That is good for diversification. Anytime the correlation between two assets is less than 1. In very short, by adding assets that are not perfectly correlated to each other, one receives the cumulative impact of the expected returns, but only a reduced impact on portfolio risk. I have re-read the Investopedia definition of diversification a few times. I agree with the latter part of the statement, but have trouble with the first section. While diversification allows you to invest in assets with high expected returns, diversification does not give the portfolio any magic bump.

Remember that expected returns are just weighted averages of all the individual investments. Correlations between assets do not impact the expected returns of the portfolio. However, it is not that simple a calculation for the risk of the portfolio. In a two asset A and B portfolio:. The first part of the equation looks a lot like the expected return calculation.

In that sense, there is a weighted average effect from risk. Diversification Impact of Strongly Correlated Assets. Because the two companies are quite similar, I shall say that the correlation coefficient is 0. If we crunch the numbers we see that the portfolio standard deviation is The difference is due to the fact that the two assets are not perfectly correlated.

However, because the correlation of 0. Therefore, we would expect an Exxon-Fine Art portfolio to yield the same expected return and risk as the Exxon-Chevron combination. In the real world, the correlation between fine art and oil companies is negligible. There is almost no correlation between the performance of Exxon and a bunch of paintings.

The same as with the combined Exxon-Chevron portfolio. Typically, stocks have a high negative correlation with the US dollar. However, gold has an opposite relationship. The US dollar tends to rally when equities are weak, thus putting downward pressure on gold. This can make gold and its related stocks move in the same direction as the dollar instead of the opposite. These three companies make up 9. Continue to Next Part. Browse this series on Market Realist: Search Now you can search stock related news and private companies such as Airbnb.

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