Non-Correlated Assets: What They Are and How They Protect Your Portfolio
Most investment decisions boil down to a simple question of risk. If an investment’s potential reward outweighs the potential risk associated with it, you have yourself a favorable setup. On the flipside, if an investment seems too risky but isn’t compensating you adequately for that risk, it may be worth taking a pass on it.
The same is true on a larger scale for an overall portfolio. You want to keep a balanced ratio of higher and lower-risk investment, and you want your portfolio holdings to be diversified among various asset classes, across sectors, in order to hedge your overall risk.
That way, if one sector starts to drag, you have buffers in your portfolio—holdings that are unaffected by news from across other industries—to offer some level of capital protection.
Volatility in the biotech sector, for instance, is extremely unlikely to affect the price of gold. But the former is certainly going to provide you with higher returns in exchange for the additional risk you’re taking on.
But what about a downswing in the overall market, say, due to some enormous economic event? Most investors are still wary following the 2008-2009 financial crisis, so fears of this sort of broad crash are not unfounded.
Plus, we’re currently in the midst of the longest bull market in history, which has many a nervous investor wondering how much longer it can last.
Whether this bull keeps on charging forward or runs out of steam is irrelevant—because there are simple ways to protect your portfolio against any market condition… even a downswing that takes most sectors with it.
One of the simplest ways to do this is by investing in non-correlated assets.
What is a non-correlated asset?
First, it’s important to understand the basic concept of asset correlation.
Asset correlation has to do with how the movements of various assets correspond with one another. It’s typical for market movements to cause various assets to move in the same general direction as one another. When that happens, it means those assets are correlated.
Correlation comes in various degrees. Two assets can have zero correlation, which means that the price movement of one has no impact on the price movement of the other. But they can also have a negative correlation—when the movement of one likely means movement of the other in the opposite direction.
The problem is that many novice investors don’t realize just how heavily correlated their portfolios actually are. Traditional assets like stocks and bonds are all highly susceptible to the same types of major market events. If big news causes one to sink, the effect is likely going to be widespread across your portfolio, unless you’re properly prepared.
That’s where non-correlated assets come in.
A non-correlated asset is exactly what sounds like: an asset whose value isn’t tied to larger fluctuations in the traditional markets.
Yes, it’s true that broad market movements can impact any asset, even those considered traditionally non-correlated. But as a rule, certain types of assets are generally less reactive than stocks to economic news and market volatility.
Common types of non-correlated assets
Some of investors’ favorite types of non-correlated assets include:
Real estate investments are less susceptible to major macroeconomic news than other types of investments. This is because their prices are tied to things like long-term leases, for which they are guaranteed revenue, and which aren’t generally impacted by headline events. No matter what else is happening, people need homes. U.S. real estate investment trusts (REITS) have a correlation to the S&P 500 of approximately 0.6, which means they’re not highly correlated to the U.S. stock market. Additionally, REITs tend to perform well in inflationary environments, which makes them a good hedge against inflation.
Emerging market bonds
Emerging markets have a slightly higher correlation to the S&P 500 at approximately 0.72%. But most investors still don’t consider this a heavily correlated asset class, since it’s made up of assets from other countries. It’s true that these investments can be risky in their own right (as any investment is). But since they’re not closely tied to the U.S. markets, they could still help you diversify and potentially lower your portfolio’s overall risk profile. One of the simplest ways to invest in this asset class is through emerging market bonds.
Gold and other precious metals
Gold is often thought of as a safe haven investment during times of market turmoil. That’s because gold traditionally has a low correlation to the overall market (approximately 0.23 between 2006 and 2015). But what makes gold a unique hedge in the market is that its correlation is known to change; when times are good for the market, the correlation is higher, but when times are bad, the correlation is lower—making it more favorable for investors in both environments.
These are some of the most common non-correlated assets, but there are countless other options out there depending on your investment strategy, including:
- Municipal bonds and other fixed income
Risk and non-correlated assets
Of course, it’s also important to note that accessing non-correlated markets like these carries with it an extra layer of risk when compared to investing in public assets such as stocks and bonds.
The first is liquidity risk. Since non-correlated are by limited in the number of investors who can access them -- after all, only one person at a time can own a particular painting or other limited asset -- there is less liquidity in the market than in something like typical public equities. You may not always be able to find a buyer for shares you’re looking to sell.
At the same time, information about these types of assets can be limited as they are not held to the same reporting and transparency standards as public assets. It can be difficult for investors to gather information about the underlying performance and long-term outlook for a non-correlated asset.
Correlation isn’t set in stone
It’s important to bear in mind that correlation levels between assets can, do, and will continue to change.
Market patterns and movements are constantly adapting. In a time of unpredictable markets, investors would be wise to keep an eye on correlation levels to ensure they remain properly diversified and protected against risk. Any experienced financial advisor should be on top of it.
As with any hedging strategy, the idea behind non-correlated assets is to lower the overall risk profile and volatility level of your portfolio. It’s not to help secure the highest possible highs, it’s to protect you against the lows.