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Correlation, Risk and Diversification

prepping peppersMany investors understand the importance of asset allocation and diversification. They choose among various assets to invest in such as stocks, bonds, real estate and commodities. Without getting too technical, the reason why investors choose different asset allocation is due to their correlation (often signified by the Greek letter rho ρ) to the overall stock market. Assets with a correlation of +1 (perfect positive), move identically to each other. That is, when one asset moves in a particular direction, the other moves in the exact same fashion. Assets with a correlation of -1 (perfect negative), move exactly opposite of each other. That is, when one asset zigs, the other asset zags.

Generally, the benefits of diversification begin anytime correlation is less than +1. For example, a portfolio with two securities with a correlation of .89 will move similar to each other, but not exactly the same. Thus there is a diversification benefit. In other words, both securities may fall in a market downturn, but one may fall further than the other. The other security dropped, but not as bad as its counterpart.

The reason correlation among securities is important is it allows investors to create portfolios with different assets, while lowering risk. This is why diversification works. One of the caveats of diversification is that the more diversified we are, we can eliminate certain risks. We can improve our risk adjusted returns. This is one of the finer points discovered by Dr. Harry Markowitz in his work developing Modern Portfolio Theory.

Investors are subject to two broad categories of risk when investing; systematic risk and unsystematic risk. Systematic risk is undiversifiable. In other words, systematic risk cannot be eliminated no matter how much an investor diversifies. This risk is also called economy-based risk, market risk, reinvestment rate risk, exchange rate risk, and interest rate risk.

Unsystematic risk is risk that can be eliminated through proper diversification. Unsystematic risk includes accounting risk, business risk, country risk, default risk, financial risk and government risk. We don’t have to invest in only one business (Enron), or one country (Greece). This Risk Chart illustrates the more securities we add to a portfolio the lower the risk becomes – up to a certain point. That point is when the curved line nearly touches, but never does, the market risk line. This asymptotic relationship means that we can get very close to the market risk line, but never eliminate market risk. Market risk is always present.

A key point for investors to understand is that diversification reduces but does not eliminate risk. Investors (as well as financial planners) should understand that there will always be risk and that there’s no such thing as a riskless asset.

Another consideration that investors must understand is that if they are properly diversified, they will not perform exactly the same as the market in a bull market. In other words, if the S&P 500 increases 30% in any given year, the investor’s portfolio should not do the same. The same is true in a bear market. A 30% decline in the S&P 500 should not mirror the investor’s portfolio. If all of an investor’s investments go up together and down together, they’re not properly diversified. A well-diversified portfolio will have some assets increase while others decrease.

This can be a tough pill to swallow when the market is seeing record gains and our portfolios seem to be struggling to keep up. Well-diversified investors are (somewhat) comforted when the market drops heavily and don’t see their own portfolios suffer as greatly.

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