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Correlation Between Financial Assets

Correlation Between Financial Assets

  • Nilza Tenguice & Yara Soto • Global Markets Analysts

When talking about long-term investment, one of the main concepts addressed is efficient portfolio management and risk diversification. Diversification of an investment portfolio is the allocation of a portfolio’s resources into different assets that have low levels of correlation with each other, with the aim of reducing the portfolio’s overall risk.

The process of efficient diversification is not a simple one and requires financial and calculus expertise in order to achieve efficient diversification. This is why many investors turn to professionals in order to have an efficient, profitable and low-risk long-term portfolio. Professional managers tend to create a portfolio with a mix of financial assets that have very low levels of correlation, even placing assets with negative correlation, in order to ensure that this investment portfolio is suitable for all economic cycles and resilient to possible unanticipated shocks that could generate volatility in the financial markets.

The concept of correlation is fundamental in asset management and, looking at the two main financial asset classes in the vast majority of portfolios, it is easy to understand why managers choose these two asset classes when they are building an investment portfolio.

Looking at the different phases of economic cycles, we can see that the performance of equity assets and debt assets behaves differently over long periods. Shares tend to be an asset with high appreciation potential in phases of anticipated economic growth, since during these periods expectations of cash flow generation are higher, contributing positively to the behaviour of these assets.

On the other hand, bonds are securities that tend to have greater appreciation potential in recessionary periods, since during these times central banks adopt expansionary monetary policies, lowering interest rates. For this reason, investors seek out these assets in troubled times, and they are therefore called safe haven assets for investors.

There are times when this correlation changes from negative to positive, altering the strength of the portfolio.These changes happen, for example, during periods of transition after an economic crash.

It is therefore easy to see that a portfolio made up of shares and bonds is a portfolio that can behave more safely than a portfolio made up only of shares or bonds, for the simple reason that historically, during different periods, these assets behave differently, i.e. they have negative correlations between them.

We need to define rules on how to allocate the assets in investors’ portfolios

However, there are times when this correlation changes from negative to positive, altering the strength of the portfolio. These changes happen, for example, during periods of transition after economic shocks, as was the case with the recent shock caused by the covid-19 pandemic. he correlation between stocks and bonds has always been negative for years, but the post-pandemic period has generated inefficiencies in distribution chains and in the demand/supply balance, with major destabilisation in global inflation.

This phenomenon created one of the most violent scenarios of restrictive monetary policy, all over the globe, with Central Banks trying to control the galloping inflation that was appearing everywhere. uring this stabilisation process, which is not yet complete, there was a fall in the value of bonds at the same time as shares fell due to reduced expectations of future growth and companies’ ability to generate results. he famous 60/40 portfolios had their worst performances mainly during 2022 and early 2023, and this was due to the historical correlation breaks between the main asset classes that made up these portfolios.

s you can see, there is no right key for all scenarios or all the time, so the ‘million dollar question’ is ‘how should the assets in investors’ portfolios be allocated?”

In the more developed markets, the 60/40 rule has been observed, where 60 per cent of assets are allocated to shares and 40 per cent to bonds. Several studies have shown that, in terms of return and risk, this is one of the allocations that has historically produced the best results over the long term. n the case of Mozambique, the reality is very different.

The liquidity of financial assets and high real interest rates create a scenario where a 60/40 portfolio has not proved to be the most efficient. For this reason, most institutional investors tend to favour a large part of their portfolios with exposure to debt assets.

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For these reasons, plus the fact that the majority of debt securities traded are variable coupon securities, these assets have shown much higher returns than those found in investments in the few shares available on the Mozambique Stock Exchange.

However, it is expected that this situation may change in the future. he structuring projects expected for the country will create very strong economic growth, where well-positioned companies will benefit.

The development of the market, with mechanisms that can boost liquidity, will also be a key variable in increasing the appetite for investing in shares and, consequently, making this asset class a viable alternative for inclusion in the portfolios of the main professional investors in the country, with the aim of increasing profitability and reducing risk through a more diversified portfolio.

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