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Correlations Among The Various Asset Classes

|Includes: GLD, IPE, SLV, SPY, iShares TIPS Bond ETF (TIP), TLT

Diversification wasn't invented by the author of modern porfolio theory - diversification is not newfangled concept.  Diversification of investments is an ancient concept. Ever since roman times, when investors lent money to finance  trading voyages, investors tended to diversify their risk by spreading their investments among several trading boats. Human beings are unwise to keep all of their eggs in one basket.

To reduce the risk of catastrophic loss of wealth and to ensure that you won't outlive your savings, diversification is the key. 

The way to achieve diversification is by building a portfolio that combines several assets which have low correlations. The definition of correlation is: how the prices of two assets move in relation to each other. If two assets have a correlation of 1.0, they move in perfect synchronization. If two assets have a correlation of -1.0, they move inversely to each other. A correlation of 0.0 means that two assets move independent of each other.

The following chart is from Seeking Alpha author Hao Jin, who ran the correlations between the S&P 500 (SPY ETF) and various asset classes since their respective inceptions.



Consider a portfolio consisting of Asset A and Asset B. They have a correlation of -1.0. If you build a portfolio consisting of 50% Asset A and 50% Asset B, then, in theory, you have constructed a low-volatility portfolio. Unfortunately real world examples of the A-B portfolio require combining assets that produce a low annual return.