Why It's Important to Understand Negative Correlation

(MoneyWatch)  Earlier this year, I gave a seminar to a group of investment advisors and asked if they knew what negative correlation meant. Not a single person knew the correct definition. Unfortunately, this experience is the rule, not the exception.

Almost universally, the response I get is: "Negative correlation means that when one investment is up, the other is down." The correct definition of negative correlation is: "When one asset experiences above average returns, the other tends to experience below average returns, and vice versa." Understanding this distinction is important when making choices about including certain asset classes in your portfolio.

To begin, the best diversifiers of risk are assets that exhibit negative correlation. Assets with negative correlation act like portfolio insurance. As I've discussed before, commodities are one such asset class. For the period 1970-2008, the annual correlation of the GSCI to the S&P 500 Index was -0.07, and the quarterly correlation was -0.14. Commodities serve as an even better diversifier of the risks of longer-term bonds, as evidenced by their annual correlation of -0.24 and the quarterly correlation of -0.22.

Recently I was asked: "How can you claim that commodities and stocks are negatively correlated after their performance in 2008, when both suffered severe losses?" The answer is in the definition. To repeat: When one asset experiences above average returns, the other tends to experience below average returns, and vice versa. The emphasis is on tends to.

The following comes from my book The Only Guide to Alternative Investments You'll Ever Need. From 1970-2007, there were eight years when the S&P 500 had a negative return. The following table shows those years and the returns of commodities in each of those years.

Year	S&P 500 Index	GSCI
1973	-14.7	75.0
1974	-26.5	39.5
1977	-7.2	10.4
1981	-4.9	-23.0
1990	-3.2	29.1
2000	-9.1	49.8
2001	-11.9	-31.9
2002	-22.1	32.1
Average Return	-12.5	+22.6

Note that both asset classes produced negative returns in the deflationary recessions of 1981 and 2001. (2008 was another deflationary recession.) But also note that the average return to the GSCI during all eight years of negative stock returns was +22.6 percent.

There are two observations we can make. First, the correlations between the two are not perfectly negative. There's a tendency for commodities to produce above average returns when stocks produce below average returns, but it's not a given.

Second, commodities hedge some of the risks of stocks (such as inflationary shocks) but not all risks. A good analogy is that they work like a homeowner's insurance policy that hedges risks such as fire, but not others such as floods. If you want to hedge the risks of deflationary recessions, your fixed income allocation should include longer-term bonds.