Why uncorrelated assets matter more than high returns
Two portfolios with the same average return produce very different outcomes. The difference is whether they fall together.
TL;DR — Two investors can have the same average return on paper. One ends up much richer. The difference is almost never skill. It is whether their portfolio crashed hard enough to force them to sell at the worst moment. Low correlation between your assets is what prevents that crash. It matters more than chasing the highest possible return.
Imagine two investors. Both average 8 percent per year for 20 years on paper.
Investor A holds mostly stocks. Every good year is very good. Every bad year is very bad. In 2022, when stocks and bonds fell together, Investor A's portfolio dropped 30 percent. At 30 percent down, Investor A panicked, sold, and missed the recovery.
Investor B holds stocks, gold, energy, and a strong currency. In the same bad year, the stocks fell, but gold and energy partially offset it. The total portfolio dropped 8 percent. Investor B barely noticed. They held through, and the recovery was full.
After 20 years, Investor B is significantly richer. Not because of better stock picks or better timing. Because they never had to sell at a loss.
This is the power of low correlation. You are not looking for assets that all go up together. You are looking for assets that do not all go down together.
Correlation is measured on a scale from negative one to positive one. A correlation of positive one means two assets move in perfect lockstep. A correlation of zero means they move independently of each other. A correlation of negative one means they move in opposite directions. The goal is to combine assets whose average correlation is as low as possible.
Stocks and gold tend to have low correlation over time. Energy and bonds tend to be negatively correlated in inflation environments (when energy goes up, bonds suffer). Strong foreign currencies and your local equities also tend to move independently.
The protection layer of a portfolio (energy, gold or bond, strong currency) is built this way on purpose. Not because each one generates amazing returns on its own, but because they do not all fall at the same time.
A calmer portfolio also protects you from your own psychology. When a portfolio falls 40 percent, almost no one holds. They sell. When a portfolio falls 10 percent because some positions are offsetting others, holding is easy. The emotional experience is completely different.
Example — In 2022, a standard portfolio of 60 percent global equities and 40 percent bonds fell about 16 percent. That was the worst year for that combination since the 1970s. A portfolio of 40 percent equities, 20 percent gold, 15 percent energy, 15 percent strong-currency bonds, and 10 percent CHF fell roughly 2 to 3 percent. The long-term expected return of both portfolios is similar. The 2022 experience was completely different. The calm portfolio was easy to hold. The standard portfolio was not.
A calm portfolio compounds. A volatile portfolio tempts you to sell at the bottom.