You’ve probably heard the saying that diversification is the closest thing finance has to a free lunch. And it’s true. Modern portfolio theory tells us that by diversifying our investments across uncorrelated assets with positive expected returns, we can potentially earn a higher return for any given level of risk. But how exactly can we use asset correlations to our advantage in the financial markets?

In this article, we’ll explore the concept of asset correlations and how they can help investors and traders optimize their portfolios. From the benefits of diversifying between stocks and bonds to finding value in stocks with unique correlations, we’ll dive into actionable strategies that can boost returns and reduce risk.

1. Bonds Offering Low-Correlation Returns

Let’s start with a classic move: investing in both stocks and bonds. Historically, stocks and bonds have had minimal correlation, making them an ideal combination for earning a better risk-adjusted return. By splitting your investments equally between stocks and bonds, you can potentially achieve a 20% higher return for any given level of risk.

While the yields on bonds have been low in recent years, the current market conditions offer an opportunity. With bond yields averaging around 5.7% and the expected inflation rate at 2.4%, you can expect a roughly 1.9% real return after inflation and taxes. Municipal bonds, with their high yields and tax advantages, can provide even better returns.

Considering the inherent volatility and periodic sell-offs in the stock market, having a portion of your portfolio allocated to bonds can be a smart strategy to dilute risk and maintain stability.

2. Capitalizing on Rising Interest Rates

The era of near-zero interest rates led many investors to seek alternatives to bonds, such as high-yielding dividend stocks, real estate, and REITs. However, as interest rates rise, certain investments may suffer while others thrive.

For example, utilities and REITs often struggle in a rising rate environment, while insurance companies tend to benefit. Understanding these correlations can help you balance your portfolio by compensating for potential losses in one sector with gains in another. By diversifying across different industries, you can hedge against inflation and reduce overall risk.

3. Uncovering Value through Correlations

Correlations can also provide valuable insights when searching for investment opportunities. By tracking the correlation of certain stocks or sectors, you can identify groups of stocks that tend to rise or fall together. This can help you make informed decisions based on the market’s potential oversight.

Using tools like Seeking Alpha’s watchlist or free correlation tools like Portfolio Visualizer, buyupside.com, or stockcharts.com, you can analyze long-term correlations and spot potential hidden opportunities. For example, if two stocks, like Apple and Microsoft, have a high correlation coefficient, but you believe one has been undervalued, it may be worth considering investing in the overlooked stock.

Additionally, anomalies in correlations can sometimes lead to buying opportunities. When a group of stocks owned by the same hedge fund experiences a simultaneous downturn due to a margin call, it could indicate a valuable entry point for investors.

Bottom Line: Intentional Investing for Better Returns

While the broader market may experience fluctuations and volatility, understanding asset correlations can guide you towards intentional investing for better returns and reduced risk. By diversifying between uncorrelated assets, like stocks and bonds, and leveraging correlations to identify undervalued opportunities, investors and traders can optimize their portfolios and potentially outperform the market.

So, don’t overlook the power of asset correlations. Take advantage of this valuable tool in your investment strategy and make correlations work for you.