Why negative correlation among asset classes is important?

Correlation of assets measures how an asset class moves in comparison to another asset class. When two assets move in the same direction together, they are considered to be highly correlated. When these asset classes move in the opposite direction, they would be negatively correlated. 

A positive correlation would mean that when one asset class return increases the other asset class return also increases. A correlation of '1' would mean that the assets have a perfect positive correlation. Investing equally in large-cap, mid-cap & small-cap does not modify the risk of the portfolio at all.

A negative correlation would mean when both asset class returns move in the opposite direction. That is when one asset class return increases the other decreases. A correlation of ‘0' means no correlation and a '-1' indicates a perfect negative correlation.

One should develop a Strategic Asset Allocation Plan. Portfolio construction and diversification are heavily influenced by the correlation between different assets.  Adding negatively correlated assets like gold, bonds, international equity along with domestic equity reduces the risk considerably.  The best asset allocation comes from combining negatively correlated assets.

Low correlation reduces the volatility of a portfolio without necessarily affecting the expected level of return. Measuring correlation provides two kinds of information:  

(a) whether the asset class returns are moving in the same or opposite direction over the long term 

(b) what is the extent to which they co-move  

We can observe from the below matrix that 4 asset classes (domestic equity, international equity, gold & debt) are mostly uncorrelated or minorly negatively correlated to each other.

Each cell represents the correlation between the two corresponding assets.

Cell Color Description Diversification Benefit -1.00 to -0.40 Asset pair with negative correlation Excellent Diversification -0.40 to 0.00 Asset pair with slight negative correlation Good Diversification 0.00 to 0.60 Asset pair with mild positive correlation Moderate Diversification 0.60 to 1.00 Asset pair with strong positive correlation Poor Diversification