Are You Really Diversified? Understanding Correlation in Investing
One of the essential concepts in investing is diversification. Diversifying your portfolio can help reduce risk and improve returns. However, many investors are not as diversified as they may think, as they don’t mind the correlation of their investments.
Many individuals who believe they are diversified hold investments concentrated in a small number of asset classes that tend to move in tandem. Even though an investor understands the importance of diversification and owns various equity holdings, the effort is lost due to the correlation between the investments.
Undiversified portfolios can happen due to many factors, but we often find a lack of understanding of how correlation works.
What is Diversification?
Don’t keep all your eggs in one basket neatly sums up the concept of diversification. Technically, diversification is a venture strategy that involves spreading your money across divergent asset classes to minimize risk.
The idea behind diversification is that by spreading your portfolio, you will be less exposed to the ups and downs of any one particular investment. For example, if you have all your money invested in equities and the stock market crashes, you stand to lose a lot of money. However, if you have a diversified portfolio, including stocks, bonds, real estate, and cash investments, the exposure to overall loss can be mitigated.
What is Correlation?
If diversion is not having all your eggs in one basket, the correlation would be having multiple egg baskets carried by the same farmer. Should the farmer trip, it doesn’t matter how many baskets of eggs you had; they all would fall.
Correlation is the connected movement between two or more things. In the stock market, correlation is identified using a scale from -1 to 1. A positive correlation means that as one asset fluctuates up or down, the other security progress in lockstep in a similar direction. A negative correlation is a case where one security moves up, the other moves in the opposite direction, and vice versa.
A False Sense of Diversification
Many investors believe owning various ETFs or index funds is the best way to diversify their portfolios. However, it is vital to remember not all ETFs and index funds are created equal. While some may offer a diverse selection of investments, others may overlap significantly, negating the benefits of diversification.
Let’s consider a couple of the largest and most popular ETFs investors purchase to gain exposure to the market while trying to diversify, the Vanguard Value ETF (VTV) and Vanguard Growth ETF (VUG). An investor may purchase shares in each instrument in hopes of smoothing out returns and reducing overall market exposure.
However, when we compare the holdings of each ETF, we find the correlation between the two to be .86 (1). In other words, there is a fairly strong relationship between the movement of each asset and the likelihood they move in a similar direction at any given time is high.
How to Design a Diversified Portfolio
There are many factors to consider when designing a diversified investment portfolio. One of the most important is asset allocation, which refers to the mix of different asset classes you hold. A well-diversified portfolio typically includes a mix of stocks, bonds, and cash. Each asset class has its own set of risks and rewards, so holding a mix of assets can help reduce overall risk while still providing growth potential.
But true diversification only begins at determining what asset classes you choose to hold. The next step requires researching which types of investments you will hold within each asset class. For example, equities can be further segmented into growth and value stocks, and then again by into of the eleven sectors (energy, financials, healthcare, etc.). Bond markets also have five primary sectors from which to choose.
Other important considerations include your investment timeline and risk tolerance. If you have a longer time horizon, you may be able to tolerate more volatility and take on more risk in pursuit of higher returns. Conversely, closer to retirement, you may want to focus on preserving capital and generating income. Regardless of your time horizon, if you cannot emotionally weather market gyrations, you may consider a more conservative portfolio irrespective of how many years you are before needing access to your investment account.
The key is to design a portfolio that aligns with your financial goals, risk tolerance, and time horizon. Doing so can help ensure that your portfolio is positioned for success.
Conclusion
It’s important to remember that no matter how many different investments you have, most will still be subject to the same underlying market conditions. This is what we know as correlation, and it’s an important concept for investors to understand. While diversification can help reduce risk, it doesn’t eliminate it. That’s why it’s important to monitor your investment portfolio regularly and ensure that it remains balanced per your goals and risk tolerance.
