By Tom Yorke Every business has its share of jargon and buzzwords used by insiders, but Wall Street may be the king of jargon. Considering the amount of television coverage given to the random movements of stock markets, it's no wonder everyone feels compelled to try and "talk the talk." That being said, here is a straightforward approach to two concepts — asset allocation and correlation — you have likely heard ad nauseum from the market pundits on television.
Think of an asset as being an investment category. Everyone knows stocks and bonds. With stocks you are a "co-owner" of the company and with bonds you are a "lender." Then there are other asset categories such as real estate, oil and gas, precious metals, commodities, foreign exchange, and something called alternative investments. Your allocation simply refers to the exact percentage or mix of each of these assets held collectively in an investment portfolio. Stocks can be divided into: domestic, international, emerging market and even frontier markets. Beyond that, we can divide them by size: large, mid, and small. Bonds can be divided into categories such as US Treasuries and agencies, US corporate, international sovereigns, international corporate (in both U.S. dollar and foreign currencies), emerging markets and also frontier markets. The rest of the asset classes can be equally confusing and digging down into commodities can go on for a while. The point to remember is each investment (asset class) has its own unique set of rules that dictate its own price movements . Each has a separate and distinct performance scenario, but they still also maintain a relationship to the performance of traditional investment choices (think US blue chip stocks). This concept is known as correlation.
An asset correlation is just a measure of how much a particular asset's price movement relates to the movement of general stock prices (again think US blue chip stocks). When the major stock markets are up or down, we want to know the correlation (relationship) of other assets we own (or are considering). The aim is not to have too many assets too closely related and behaving the exact same way: good or bad. It's important to understand and consider correlations carefully when building a portfolio. Not only do we not want all of our assets declining in value simultaneously, but we should be looking for opportunities to earn a return while also lowering our portfolio's volatility and hence its exposure to the general stock market. The idea is to diversify yourself across various stocks and other assets, appropriate to your specific situation. That's because a properly diversified portfolio can help you sustain any future market downturns. Given the complexities involved, trying to pick the best performer from each group more than once is extremely difficult. We feel it's best to decide on an appropriate asset mix you are comfortable with, combine it with a regular review, and stay the course. Some years will clearly be better than others, but trying to chase each year's best performer is impossible and more likely to cause added stress and investment losses.