Asset Class Correlations: It’s All Bunk

Asset Class Correlations

Ever hear about asset class correlations? Well, it’s all bunk.

The idea of asset correlations is this: A 1.0 is perfect correlation. Meaning if Asset X moves up then Asset Y moves up in lockstep. A correlation of -1.0 is perfect negative movement. If Asset Y moves up then Asset Z moves down. Usually the range of correlations falls between the perfect positive correlation of 1.0 and perfect negative of -1.0.

You see this in investing books all the time. Stock asset classes X and Y have a correlation of 0.67 while bonds A and B have a correlation of 0.22, etc. You just throw them together and you get instant diversification! It looks so scientific being two decimal places and all.

Well, allow me to let you in on a secret: This information is worthless at best and dangerous at worst.

A World of Correlations

In the investing world many decide to build a portfolio using historical correlation data. They look at all of these assets over the years and assign a correlation number between them to try to figure out a relationship and how much of each you should own.

For instance over the past 30 or so years:

Total Stock Market and the Total Bond Market have a correlation of about 0.34. Meaning that some of the time are they moving upward at the same time but sometimes they aren’t.

Total Stock Market and Total International Stock Market have a correlation of 0.66. A stronger correlation indicating that if one is going up the other probably is, too.

Total Stock Market and Gold have a correlation of -0.27. Meaning that if the stock market is going up in value that gold is probably going down and vice versa.

Now you take a bunch of assets with different correlations and you are hoping that when one zigs the other zags. This diversification effect means over time that as one is gaining in value another is falling. During good markets you may give up some gains, but in down markets you have some assets that should do well to offset the losses.

Good theory, but normally used poorly in practice.

The reality is that asset class correlation data is irrelevant and can get you in trouble. In 2008 for instance many people held assets that supposedly had low correlation historically. Yet, when the markets crashed the correlations went up sharply and they all went down together. The diversification selected failed and large losses followed. Many claimed that “Diversification failed in 2008.”

Diversification didn’t fail. What failed are how portfolios were built to diversify the risks.

There are two primary failures with looking at asset class correlation alone:

1) Looking at correlation data without considering the underlying economy at the time covered.

2) Correlation data encapsulates big blocks of multi-decade returns which loses visibility into the specific events happening under the covers.

Let’s talk about these two things.

It’s Hot in Miami and New York – Who Cares?

What about the underlying economy? Why is this a big deal?

Let me explain using the weather. Below is a list of average temperatures in Fahrenheit in three cities:

New York Miami Sydney
30.7 67.2 71.8
31.5 68.5 71.6
39 71.7 69.6
49.8 75.2 64.9
60.8 78.7 59.4
70.2 81.4 55
75.6 82.6 53.2
73.8 82.8 55.4
66.9 81.9 59.4
55.9 78.3 63.7
44.8 73.6 66.9
34.5 69.1 70.2

I run this through my spreadsheet and these are the correlations I receive:

New York to Miami Correlation: 0.99

New York to Sydney Correlation: -0.98

What this tells me are that the temperatures of New York and Miami are highly correlated and the temperatures in New York and Sydney are not. When temps are going up in New York they are going up in Miami and when they are going down in New York they are going up in Sydney.

But why should this be? To many I see talking about asset class correlation the analysis stops here. They would simply say (if you built portfolios from cities) is:

“Just buy a little New York, a little Sydney to diversify and some Miami to boost returns.”

But when you ask a more fundamental question about why these cities are or are not correlated you may not get an answer. So you look further and think that perhaps it’s related to the months of the year. Hmmm…now that’s interesting.

Let’s add months to our chart:

Month New York Miami Sydney
January 30.7 67.2 71.8
February 31.5 68.5 71.6
March 39 71.7 69.6
April 49.8 75.2 64.9
May 60.8 78.7 59.4
June 70.2 81.4 55
July 75.6 82.6 53.2
August 73.8 82.8 55.4
September 66.9 81.9 59.4
October 55.9 78.3 63.7
November 44.8 73.6 66.9
December 34.5 69.1 70.2

Ok that adds some more context. Clearly you see the month of September, then October, then November, then December. What’s this? Why are the temps in New York and Miami falling but Sydney is going up? The months are all the same.

In Some Places, Santa Claus Wears a Bathing Suit

Let’s look deeper. Let’s ignore the months and look at the seasons instead. As you probably know, the Northern and Southern hemispheres have seasons that are reversed (When I was in New Zealand for instance, Santa Claus in December was shown to be in summer shorts carrying a surfboard and not wearing a big heavy coat):

Northern Seasons

Winter: December, January, February

Spring: March, April, May

Summer: June, July, August

Fall: September, October, November

Southern Seasons

Summer: December, January, February

Fall: March, April, May

Winter: June, July, August

Spring: September, October, November

With more context this correlation data now makes sense. The temperatures fall in New York and go up in Sydney because of the seasonal differences. It has nothing to do with the cities being correlated, the months of the  year, etc. The temperature changes are due to the seasons and if I ran a correlation of temperature changes to seasons of the year you’d find that it is almost a perfect 1.0 match regardless of location on this planet.

What’s the Point?

Asset classes don’t move because of each other. Asset classes move because of the seasons in the economy.

Asset class correlations without an economic explanation why they move is dangerous. This is the problem of using asset class correlations alone to build a portfolio. It’s also why you should ignore tables of asset class correlation data you see in books, articles and other places. If they aren’t tying those assets to the economy then it’s all wasted ink.

Changing Seasons of the Economy

We come then to a core concept of the Permanent Portfolio. It is not built around this idea of asset class correlations. It is built around the idea of looking at the changing seasons of the economy:

1) Prosperity
2) Deflation
3) Inflation
4) Recession

Bonds don’t move up sharply in price because stocks moved down. Bonds move up because deflationary forces make it a good investment. Gold doesn’t move up because bond prices are falling. Gold moves up when people think inflation is becoming a threat. Stocks don’t move up because gold prices have come down. Stocks move up in price when people think the economy is going to be prosperous.

This is the difference between the Permanent Portfolio allocation and others. The assets chosen respond the best to the four conditions of the economy outlined above. Those assets are (for US Investors) Stocks, Long Term Treasury Bonds, Treasury Money Market Funds and Gold.

A Five Foot Deep Creek Can Still Kill You

So what about the second error I talked about above? The one where I said asset class correlation data masks some truly ugly details by bundling everything up over multiple decades?

Well it’s just something that averages do. They’re average. Taken as weather you may think the average January temperature above for New York is 30.7 degrees. However what you don’t see are those nasty years when it was in the low twenties with plenty of days in the single digits or lower.

It’s related to that old saw in statistics that a six foot tall man that can’t swim can still drown in a creek that is an average depth of five feet. What this average ignores is the creek is one foot deep in some places but 10 feet deep in others. It’s these extremes that can really burn investors and you don’t see them when you look at some correlation number that spans 40 years. The extremes are buried in the data and until you look you won’t see when the correlation of assets suddenly went to 1.0 perfect and huge losses incurred in certain years (witness 2008’s losses in what some thought were diversified investments).

Correlations Don’t Change Over Time

Incidentally, the changing of the economy is also why advocates of correlation data say “Correlations change over time.”

Actually, correlations don’t change. At least not when you look at the data from an economic cycle standpoint.

Stocks and bonds don’t suddenly become correlated out of the blue. What these folks are seeing is the economy shifting underneath that causes periods of over and underperformance for assets. The correlations though are not “changing.” The only thing changing is the time period they are analyzing and what the economy was doing and they are coming away with the wrong conclusions. Statistical tools are powerful when used correctly, but here they fall flat on their face because they are being mis-applied.

“Correlation does not equal causation” – Asset class correlations provide no explanation for cause and effect. Only tying the assets to the economy explains their price movements.

An Epiphany – At Least for Me

I took time to explain this because it was really an epiphany for me personally and answered many questions about how diversification can be made to work by applying economic understanding to the problem. In fact, I firmly believe it is a serious and grave error to not consider economic impacts on the asset classes you own and rely on correlation data only.

So ignore this asset class correlation stuff. It doesn’t answer the questions you need to have answered about investments and can get you into trouble by supplying you with a false sense of security. Instead, own assets that correlate to what the economy underneath is doing. This is where the power of diversification can really work for you.

Craig Rowland

I own the place.

16 Responses

  1. MachineGhost says:

    Indeed, but economic cycles get into the realm of tactical asset allocation which is pooh-poohed by Wall Street and academia.

    While it may not matter if you “buy and hold” a PP, I still think it is important to understand the true causations of what makes the underlying assets move. In this regard, Browne had it a little wrong as he was only a product of limited economic understanding at the time.

    Gold does not go up in inflation. It goes up when real long term yields are declinig, another way of saying that recession is around the corner because future returns on capital are decreasing (gold does this first, before bonds respond). Not as powerful, but gold also goes up when real short term yields are negative, i.e. currency is being devalued below the rate of interest being paid, causing people to hoard real assets. Inflation is not going to make gold go up per se if long term yields are increasing and/or short term yields are above the cost of carry. Far too many confuse an increase in bond yields as “inflation” and expect the same simplistic logic to translate over to gold.

    Given the above facts, it becomes obvious there is really only three economic cycles for purposes of asset allocation:

    1. Economic Growth (Prosperity/Inflation): Stocks
    2. Economic Decline (Deflation/Recession): Fixed Income
    3. Uncertainty/Fear (Negative Yields/Stagflation/Bubble Tops): Real

    Cash and bonds are not distinctive asset classes. They are the one and the same, merely of different levering and durations of credit risk, ultimately sovereign risk if limited to non-corporates (excluding bail outs).

    As far as real assets go, history has shown that people prefer gold under uncertainty and not the other commodities. But there are exceptions, like houses, cars, toilet paper, soap, etc. especially if such can be bought with increasing worthless currency. It is also important not to confuse demand bubbles in commodities under proisperity or stagflationary environments with clearly hypernflationary scenarios such as war or Chavez/Castro-style socialist government takeovers. In the former, you can do well holding real assets, in the latter only gold (or diamonds) will suffice.

    As far as averages masking periods of underperformance, it is far superior to construct the PP utilizing the historical maximum drawdown for each of the 3 economic cycles over hundreds of years of history, because the standard 25×4 model is moderately risky. Again, people are simply not prepared for sovereign bonds to lose 80% of their value or gold to lose 80% of their value or soveregn currency to devalue into worthlessness.

  2. Adam Ash says:

    Great post, Craig.

    I think that this data-mining issue is a problem in a lot of fields outside of investing.

    Not uncommon in science for researchers to reach faulty conclusions based on numbers that are not really supported by an underlying theory of some kind. Numbers should support theory and vice versa. That’s what research is all about.

  3. craigr says:

    The biggest problem with statistical tools applied to investing is they are being used inappropriately. IMO. The investing world just doesn’t work as smoothly as standard statistical analysis expects. This is a point that both Benoit Mandelbrot and Nassim Taleb have argued in their books for years as well.

  4. [email protected] says:

    New to this type of portfolio. When I first saw a growth chart of the permanent portfolio I thought were has this been all my life.
    Is this the basic etf”s and funds to buy?
    TLT or FLBIX
    IWV or FSTMX or VTSMX or VTI
    SHV or SHY

  5. shadows of truth says:

    craig, i’d be interested to hear your response to MachineGhost’s very interesting points.

  6. craigr says:

    Well we will differ on these points. I don’t think tactical asset allocation works. It relies on trying to predict the future which I don’t think works.

    But no portfolio can protect against everything. An 80% decline in sovereign debt would be very hard on just about everyone whether they hold gold or no. But at the same time this kind of default does not happen often enough to justify not holding any bonds. The portfolio can protect against many extreme circumstances, even those we cannot predict, simply by looking at the four basic economic cycles. I have looked at the history myself and I do believe Browne is correct in his deduction of four economic conditions. These conditions are largely caused by the interplay of central banking credit manipulation in the markets (classic Austrian economic theory).

  7. EdwardjK says:


    To say that correlation does not matter is disingeneous. The Permanent Portfolio is built around the entire concept.

    The basic premise of the PP is that at least one of the four components is increasing in value while one or more of the other components are declining. This occurs because of correlation between the asset classes.

    Also, using 2008 as an example where correlation failed is also disingeneous. Unless you stuffed cash in your mattress, your investments lost value that year. And the PP did as well.

    Craig, time for a nap.


  8. Dan says:


    There’s a difference between losing 20-40% of your wealth in 2008 and breaking about even, which is what the PP did. Show me your caluclation of a 2008 PP loss, because mine gives me a slight positive return, which is tremendous given the shock 2008 was to our economy, and how small nuances of gold, long-term treasuries, and even cash (treasury MM account vs others) within the PP made all the difference in the world as to the portfolio’s return.

    Take a look at gold vs a commodity basket.

    Take a look at LTT’s vs other long-term bonds.

    These are unpopular assets, but as a team have provided amazing protection against stock-losses in the past, but are also macroeconomically situated to do so in the future.

    The portfolio’s built around the macroeconomics of the correlations, not some datamined number. What he’s saying is that the only way to truly rely on noncorrelation is not by looking at a datamine of different assets, but that you need to understand the underlying economic cycles behind the assets so you can rely on that correlation in the future.

    Ed, time to wake up.


  9. craigr says:

    The Permanent Portfolio is built around asset class correlations to the economy, not each other. That’s the takeaway. I’ve seen many investment books that talk about asset class correlations to include multi-page tables of the figures (with a disclaimer that they change over time). The point of this post is that this information is largely worthless. The economic factors behind the asset classes is what truly matters.

  10. craigr says:

    Also the Permanent Portfolio did not lose value in 2008. Trust me because I lived through it. Yes the individual stock asset class did suffer, but the gold and LT bonds especially pulled it all out of the muck. But this is because the assets chosen were done so based on economic conditions. LT bonds were linked to deflation. In 2008 we had a deflationary event and they went through the roof. Just as designed and just as economic theory dictated.

  11. MachineGhost says:

    Guys, whats with all the consternation? The original point craigr made stands: the PP is a strategic asset allocation for correlating to different phases of the economic cycle. That is not in dispute.

    My point was the empirical historical evidence underpinning Browne’s economic theories are slightly wrong. For instance, so-called “Tight Money” that Browne identifies as a phase is actually the environment which precedes the beginning of an economic expansion where REAL interest rates are rising (higher real interest rates attracts capital to an economy). This is the corollary to gold increasing when REAL interest rates are decreasing at the end of a economic expansion, which Browne does not identify as a phase. Browne simply did not fully understand the function of REAL interest rates vs inflation or the differences between productive and unproductive inflation; still a very common misunderstanding today, so you wind up with simplistic truisms like “Gold goes up in inflation” despite the evidence to the contrary from 1981 to 1999 (what, did inflation just cease to exist during that time frame?!!). Its not all his fault though; much of the empirical economic evidence we have today (that is widely ignored by journalists and bloggers in favor of economic fictions) was simply not available in the late 70’s and early 80’s.

    If you don’t understand any of what I wrote, then don’t worry about it. It’s not that important to successfully implenting the PP. The difference between Browne’s simplistic 25%x4 and empirical reality for the U.S. is not that significant: -8% for gold, -15% for cash and -5% for equities.

    At the end of the day, when stocks and bonds and cash all collapse with 90% drawdowns due to a sovereign default (Greece???), no amount of gold will cover 100% of your losses if you want a permanent portfolio that grows during the other 99% of the time…

  12. MachineGhost says:

    Furthermore, if one decides to implement a post-modern PP in a world were the U.S. dollar may no longer the world’s reserve currency, then there will be no choice but to internationalize the assets to mitigate the sovereign risks, which is the single largest weakness of Browne’s PP. But, one darn well better understand what truly drives the underlying assets, as I’ve tried to outline. Jumping out of the frying pan and into the fire isn’t too smart.

  13. Dan says:

    Machine Ghost,

    I totally agree with you in many ways… the nuance of gold performing well during negative real interest rates creates a situation (like 1981), where it will snap back like a banshee if short-rates rise to beat inflation. This may or may not affect LT bonds or stocks immediately, so you could have a very painful drawdown without enough cash bounce to pick you back up.

    I always thought that the PP should be weighted either for growth prospects or for volatility (or lack thereof). Since gold 1) is the most volatile PP asset, and 2) will be least likely to stabley consistently follow its “inflation” macroeconomic cycle (not that you want it to match CPI… you actually DO want it to return amazingly during negative real rates), you have what is absolutely the most likely to throw you into a drawdown… as it did in 1981.

    Conversely, if one believes that gold WILL react exponentially when it needs to, then to hold 25% of it is a bit much for someone not trying to speculate, but trying to come up with a “permanent” lifetime allocation for the portfolio that’s a bit less apt to drop 1981-style when rates finally rise.

  14. shadows of truth says:


    so are you suggesting that the safer/more optimal portfolio mix is the following:

    17% Gold
    10% Cash
    20% Equities
    53% 30yr Treasuries


  15. MachineGhost says:

    Technically, as individual asset classes, the optimal portfolio based on actual U.S. history is:

    51.72% Bonds
    20.71% Stocks
    10.56% Cash
    17.00% Gold

    “Optimal” in my worldview is the compounded annual return for “return” and maximum peak-to-trough drawdown for “risk”.

    I consider the most important distinction being the stocks capped at 20% which is the maximum allocation to avoid imploding any future retirement portfolio via inflation-adjusted withdrawals.

    As I’ve mentioned before, the PP concept will only go so far because systematic sovereign risk permeates the entire economic system through the cash, to the bonds to the equities. The gold is the coup de grace and “paper gold” of any form is just not going to do in a FUBAR scenario. For example, the Argentine 5 Peso minted during 1881-1896 (.2334 ounces of gold) is now worth more than 500 trillion times the original face value.

  16. Dan says:

    Funny thing MG,

    I recently set my dad up with my suggestion for him (he’s 65), as a 40/30/20/10 (Bonds/stocks/gold/cash) PP.

    Not exactly what you’ve got but pretty close… Those ratios are based on nothing more than the principles of maximizing the return/volatility ratio, and the nice-sounding simplicity of 40/30/20/10.

    My will to reduce gold was NOT because of thinking it’s not going to go up… in fact, I respect gold enough that I think it does more than enough for me at lower levels. Cash is nice for liquidity, but once you get past 1-year’s living expenses you’re playing it too safe IMO.