Correlation among asset classes

why is this so???

In choosing asset classes,the correlations of returns WITHIN an asset class shd be relatively high and the correlations of returns BETWEEN asset classes shd be relatively low in comparison.

That’s because you want to diversify as much as you can in your portfolio. See, same asset classes are similar in “specific to that asset class” risk. i.e. unsystematic risk.

So, you want to reduce unsystematic risk cuz you cannot get rid of market risk. I am not sure, if you can. S2000magician might be able to guide us better on this. Also, don’t believe me verbatim. This is what I believe.

  • The fundermentals (regulation, economic factors etc) affecting a particular asset class broadly affects most assets in that class in a similar way, though to greater & lesser extents. So the assets WITHIN the particular class would broadly tend to move together in the same direction.

  • On the other hand if you take different asset classes (say, Equities, FI, Real Estate), there would be fundermentals that are common to all hence driving all classes together (particularly economic variables). There will be other factors too that affect only specific classes (e.g. regulations such as planning permission in real estate) and not affect (or may be inversly related with) the others. So you can see that there are dampening effects in this scenario.

Without getting into the hard details it is clear that correlations in bullet 1 would tend to be greater than bullet 2.

A conclusion from this is that whilst aiming to maximize returns, spread your investment across(BETWEEN) more asset classes in order to reduce concentration risk and increase diversification benefit.

Hope it helps.