Diversification & Correlation Investors need to know the difference

We hear all the time that spreading your portfolio’s holdings across many classes of assets is one of the best defenses against losses when the bears hit Wall Street. There is a good chance your diversification strategy may now not work as you intended, though.

Here’s why.

Diversification 101

The cornerstone of diversification is a mixture of investments, each of which has broadly differing patterns of strength and weakness. That way, strengths in one investment can potentially offset weaknesses in another at any given time. The greater the difference in performance patterns of any two investments, the bigger the potential benefit from diversification.

Historically, such alternative investments as real estate and precious metals provided a non-correlated counterbalance in portfolios to traditional holdings such as stocks. Over the past decade, some investments that once differed significantly began performing more alike and this reduced their potential to offset each other’s ups and downs in your portfolio. As financial instruments and global markets became increasingly liquid and accessible, different asset classes became more closely interrelated.

Correlation 101

Correlation is a common measure of the variation in performance between two investments.

The closer two investments’ correlation is to zero, the greater their potential to diversify your holdings. In other words, the less alike two investments are, the less they can drop in the same market conditions.

Different asset classes once tended to correlate at a relatively low level. And the correlations they did have tended to vary even as one pair became highly correlated, others went in the opposite direction.

The chart on the next page was developed by research firm Morningstar and shows how diversification potential for 14 asset classes stands today.

What the Numbers Mean

A correlation of 1.0 means that all changes are synchronized exactly. A correlation of minus 1.0 means that the amount of change synchronizes precisely but that the changes run in opposite directions. A correlation of 0 denotes no statistically measurable relationship between changes in one set of returns and changes in another.

Convergence of key asset classes’ performance may be clear but the underlying reasons are complex. Some point to the explosion of ultra-diversified hedge funds and exchange-traded funds. Others credit the melting borders of international trade. No one answer seems to constitute a sole reason.

Correlation Matrix of the 14 Asset Classes in 2018

Investors need to consider not only the risk and reward potential for each investment category but those categories’ correlations, as well. This lets you know how much of a portfolio can rise or fall at once.

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