All individuals, organizations, industries, and even national economies are subject to routine setbacks, ranging from minor inconveniences to major catastrophes. The recent performance of the U.S. economy, the largest economy in world history, is a good reminder that even something that may sometimes seem miraculous and invincible is subject to downtrends, cyclical or otherwise.

An investment portfolio is likewise not immune to setbacks. In fact, setbacks are so likely to occur that the best defense may be to expect some losses but to employ a method to help reduce any damage.

Up vs. Down

Different types of investments are subject to different types of risk. For example, on days when you hear that stock prices fell, it would not be unusual to hear about a rally in the bond market. This tends to occur when investors decide to shift away from stocks because the risks facing debt instruments might be more palatable.

However, a strategy of identifying investments that face offsetting risks is much more complex than simply spreading your money among stocks and bonds. Such a strategy would involve first identifying correlations between different investments.

In the financial world, correlation is a measurement of how two securities perform in relation to each other. Securities that are negatively correlated will have prices that tend to move in opposite directions. Securities that are positively correlated will have prices that move in the same direction.

By examining the historical relationship between the performance of two different investments, it’s possible to compute a correlation coefficient, which measures the degree of correlation. A correlation of +1 means the investments have a perfectly positive correlation and will perform identically. A correlation of –1 means they have a perfectly negative correlation and will always move in the opposite directions. A correlation of zero means that the two investments are not correlated; the relationship between them is random.

Assets that have relationships that can be correlated might be found in different industries, sectors, or asset classes. Few asset groups are perfectly negatively correlated, but your portfolio may still be able to benefit from the correlation principle.