In recent years and especially since 2008, correlation among various asset classes has become a hot topic. Basically, correlation is how an investment moves in relation to other investments.

In short, correlation measures how closely two variables move together over time. For example, two pharmaceutical stocks often have a high degree of correlation because the same forces influence their share prices. In contrast, gold stock prices are not closely correlated with pharmaceutical stock prices because the two are influenced by different factors. Therefore, ideally when building a diversified portfolio to minimize risk, an investor would want mutual funds or even individual equities that will perform differently from each other in any given type of market.

In general, a high correlation is considered to be .70, a moderate correlation is considered to be .50 to .70, while 0.3 generally is considered to be relatively "uncorrelated". A perfect positive correlation would be 1.0, while 0.0 would be perfectly uncorrelated, and -1.0 would be perfectly negatively correlated. The closer the ratio is to 1.0, the more closely the rates of return will move in conjunction with one another. Very close positive correlation would be what investors could expect among several index funds whose goal is to match the same underlying index such as the U.S. stock market.

Very few pairs, let alone groups of investments, such as mutual funds move in exact tandem with each other or, for that matter, totally opposite of one another. Most are somewhere in between. The key to building a good asset allocation portfolio is combining investments in a portfolio that have low or negative correlation with one another. Ideally, one would like each investment to have low correlation with each other regardless of how many investments that they have.

The anti-thesis of building a portfolio with low correlation investments is the thought process that many investors and advisors falsely have, which is that when they buy several different large company mutual funds in the same portfolio that they are diversifying. In fact, such a strategy does not reduce risk, or at best minimally so. This is simply because most large company mutual funds react the same way to stock market movements and are therefore highly correlated due to the fact that they own many of the same underlying equities or ones in the same industries in similar proportions. Combining investments with low or negative correlations to one another allows the portfolio to protect itself and as a result, insulate itself from financial market downturns.

Frequently, investors and many advisors assume that a portfolio comprised of 100.0% bonds is very conservative and has very little risk. This is not necessarily true! If interest rates rise, bonds very well could deliver losses. A portfolio holding 70.0% to 75.0% bonds and 30.0% to 25.0% equities potentially could provide an investor with increased returns for slightly less risk than an all bond portfolio. Separate mutual funds that invest in money market securities, currencies, commodities, real estate, hedge strategies, managed futures and limited partnerships when mixed together with traditional equity and bond investments can reduce volatility even further.

Ultimately, such combining and equally weighting investments that move in dissimilar ways can reduce the volatility of a portfolio while delivering potentially smoother returns than the stock market itself. This type of strategy is a basic building block of a lower volatility portfolio.