This is just a quick note to point out a useful tool that I ran across while researching our ideal asset allocation. Simply head over to Adviser Online’s Fund Correlation Tool and you can easily determine the correlation between any pair of Vanguard mutual funds.
In case you’re not familiar with the concept of correlation, it’s simply a statistical measure of the degree to which two variables change in concert. A correlation of +1 refers to an increasing linear relationship, whereas a correlation of -1 refers to a decreasing linear relationship. A correlation of zero means that two variables move independently of one another.
While I’m grossly oversimplifying things here, a properly diversified portfolio contains a variety of different security classes with low or even negative correlations. Having this sort of investment mix helps to ensure that when some of your investments are suffering, others are thriving (or at least suffering less), thereby reducing your overall investment risk.
Note that the fund correlation tool reports the correlation coefficient in terms of percentages, so the data points can actually range from -100 to +100.
Some examples…
Large Cap Index vs. Small Cap Index: 89%
Total Stock Market Index vs. Total International Index: 74%
Total Stock Market Index vs. Total Bond Market Index: -17%
Even if you don’t have access to Vanguard funds, this is a great tool for getting a feel for how different asset classes perform relative to one another.
As you can see from above, domestic equities exhibit a relatively strong positive correlation with each other, even when comparing between large and small cap stocks. Likewise, domestic and international equities are reasonably well correlated, though less so than large vs. small cap stocks.
In contrast, stocks and bonds have a slight negative correlation, meaning that increasing in stock values are typically accompanied by decreases in bond prices, and vice versa.
Gotcha… Yes, I can see how decreasing vs. negative could be confusing. I was thinking in terms of the slope of the relationship. Thanks for the clarification. 🙂
Correction withdrawn as it looks like Wiki has your terminology also. My thought was that your wording implied the linear relationship is decreasing (growing weaker) as it reached -1.
We must have different backgrounds, but correlations are always described as positive/negative linear or direct/inverse linear in my field to avoid this very confusion.
Steve: I’m not sure exactly what you’re trying to correct. Linear = linear. Had I said “approximately linear” then you’d have a point, but when someone specifies a linear relationship, it’s typically in reference to a 1 to 1 (or 1 to -1) relationship (i.e., “perfectly” linear).
Not to get too geeky, but a correlation of -1 is also a perfect linear relationship, just as +1 is, albeit inverse. Just trying to clarify your “a correlation of -1 refers to a decreasing linear relationship” statement.
Nice tool though, very useful.
This is an useful tool. Does anybody know how far back they go in calculating these correlations? I’m guessing it’s 36 months since that’s what Vanguard reports on their website. It would be even more interesting if they had a way to compare 3 or 4 funds with each other in a portfolio and calculate the CAGR and Std Dev of the portfolio over the past 36 months or whatever time period they use.
Thanks for linking to this tool, it’s a new one to me. I’m surprised to see large cap to small cap at just 89%. Of course, correlations change over time, so we need to keep checking back.
One thing I’ve been curious about in terms of “secure” portion of a portfolio is why the bonds are usually mentioned instead of CDs. Sure at some point in the 80s, bonds had higher yields, but recently, the yield on CDs is higher than yield-to-maturity on AAA bonds — just searched through AAA bonds on my brokerage account.
I am not talking about bond funds, since these don’t have maturity date and carry a whole lot more risk than individual AAA-rated bonds.
This is a question to those more knowledgeable than I am. A bunch of my CDs mature in May, and I\’ve been trying to find some good place for them which has to be in \”safe\” portion of my portfolio to maintain my desired allocation. I’ve already bought max allowed number of series I bonds for the year.
Wow, I never thought concepts from my “Probabilistic Methods” class would ever be useful for me. Makes me wish I didn’t sell my textbook!
This is why a little exposure to bonds is always a good bet. I wouldn’t put a large percentage or my portfolio there but having a little balance doesn’t hurt.