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Correlations And The Art of A Terrible Tango

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Topic: Gold
Publication Type: Investment Cases
Correlations And The Art of A Terrible Tango

The Diversification Discrepancy

In a mathematical sense, gold is predictably unpredictable, rendering it a prime candidate as a diversifying asset.

While diversification may be one of the most common refrains in finance, the irony is that it is home to widespread misconceptions among investors, both novice and seasoned alike.  Everyone intuitively understands the wisdom of “don’t place all your eggs in one basket” – such logic extends to everyday life – but investors often find themselves with far fewer “baskets” than they even realize. 

What factors account for this discrepancy in diversification?  

Perhaps the most influential factor is a misreading of what actually counts as a distinct basket for investment purposes.  While investors generally succeed at including many different assets in their portfolios, giving the appearance of diversification, the reality is these investments often behave too similarly to count as separate baskets.

The challenge? Most assets are naturally correlating, following each other’s footsteps to the market’s tune. In order to diversify, however, investors should consider assets that dance to their own beat, the posterchild of which is gold.

Step 1: Correlations

When managing a portfolio, how can investors discern if two assets are actually two distinct baskets, or if they are just one basket masquerading as two?

While outwardly a simple question, this is precisely the issue that stumped the global financial system leading up to the 2008 subprime mortgage crisis. Essentially, what where thought to be hundreds of thousands, if not tens of millions of individual investments all turned out to be one unfathomably massive basket. And then the bottom fell through, a textbook example of naïve diversification gone awry.

Related: Are You Actually Set up for Income?

At the heart of this one or two basket problem is correlations- the statistical measure of how two investments move together. 

The challenge with non-correlating assets is not identifying their role in the portfolio, but simply finding them in the first place.

Consider the analogy of two tango dancers: a perfect correlation would be the two dancers performing in unison, absolutely lockstep. By contrast, if they were perfectly uncorrelated, the dancers would be so disjointed that knowledge of one dancer’s movements indicates nothing of the other’s steps. Ironically, it is this “bad dancing” that is prized in portfolios, with the assets in part canceling out each other’s diverging movements.

This type of behavioral independence is the core feature of diversification, the idea being to draw upon non-correlating assets to add more truly distinct baskets to the portfolio.  In building portfolios, however, investors often focus on the risk/return characteristics of specific assets and neglect how the correlations shape the overall picture. 

Learn More: How Much of Your Income is Mental? When Behavior Fallacies & Investing Collide

Unless these assets bring new correlative properties to the portfolio, the investor is fundamentally duplicating a bet already in the portfolio, which hardly counts as adding a new basket to the mix.  More credible diversification tools are necessary.

The Golden Diversifier?

The challenge with non-correlating assets is not identifying their role in the portfolio, but simply finding them in the first place.

Almost everything in finance is influenced at least to some extent by other market factors; genuine independence is a scarcity. It is precisely this facet of gold that lends it such value as an asset class, given it is radically independent from the other common building blocks in portfolio construction. 

Notes: Single-factor regressions of gold against four common market indices on a weekly total return basis from 12/31/2004 to 3/29/19. Correlation coefficient R is expressed on a range of -1 to 1, where -1 is a perfect negative correlation, 0 is no correlation, and 1 is a perfect positive correlation. (*Real Estate Performance is based upon the DOW Jones REIT Equity Total Return Index)

The diagram above charts the performance of gold against other major asset classes on a weekly basis. The blob-like nature of the results illustrates just how slim of a relationship exists in each case, as a stronger correlation would see the points more closely resemble a perfect line (imagine lockstep movements, clearly not the situation at hand). 

Over the 15-year period since 2004, gold managed a correlation of only 0.007 against the S&P 500 and 0.162 against the Bloomberg Barclays US Aggregate Bond Index, both extraordinarily low values. 

As a frame of reference, even utilities, the least correlating market sector, could achieve a correlation only as low as 0.600.  Despite all the fanfare about utilities performing as a defensive asset, this sector still traded in the same direction as the market roughly 80% of the time. This sort of examination underscores why questioning how many baskets are actually in your portfolio is such a resonating endeavor.

More Research: Will the Real Commodities Index Please Stand Up?

If it were not enough for gold to maintain zero and near zero correlations against the two largest allocations in most portfolios, its independent streak extends further still.  While real estate is considered a staple in diversification, not only is gold far less correlating to the market than real estate (gold at 0.007 vs. 0.731 for real estate), but gold is nearly uncorrelated to real estate itself.

This sort of examination underscores why questioning how many baskets are actually in your portfolio is such a resonating endeavor.

Perhaps the most striking detail of all, however, is that gold is almost perfectly uncorrelated to the VIX Index at 0.046, undercutting the narrative that gold is a hedge against market volatility. In a mathematical sense, gold is predictably unpredictable, rendering it a prime candidate as a diversifying asset.

The Independent Basket

What the data reveal quite conclusively is that gold is an independent asset with its own organic return, a veritable Holden Caulfield of the investment ecosystem. Extending the tango analogy, regardless of what its partner does, what the tune may be or how often the tempo changes, gold keeps to its own rhythm.

Even if an investor were to know, with cold certainty, what the market would do over the next week, month or year, she would still have exactly zero information on how gold would perform.  This staggering notion illustrates the elegant power of diversification, and what exactly it takes for an asset to count as a different portfolio basket. All considered, gold is a certifiably bad tango dancer, and it is this factor that lends it value in the portfolio.


Investing involves risk including the possible loss of principal. Diversification does not guarantee a profit or protect one against a loss. There are no guarantees that following a particular investment strategy will produce the desired results.

Ryan is Director of Research at GraniteShares, and has focused his career on spanning the divide between traditional active management and indexed strategies. He has worked as an analyst at a number of hedge funds, including Tudor Investment Corporation, before developing first to market, scalable strategies utilizing the ETF wrapper. He graduated from Boston College in the Honors Program with a Bachelor of Arts degree in Economics and Philosophy. He earned his CFA charter in 2019.

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