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Featured Advisor

Srbo Radisavljevic
Managing Principal/Investment Advisor

Edge Portfolio Management


State: IL

At Edge, a low client to advisor ratio allows for personal and customized service for each individual.  Our goal is to work as a team for each client to provide not only portfolio management but wealth coordination and financial planning.  We make every effort to have frequent communication with our clients and to provide timely response to calls and emails.  I also enjoy spending time with my wife and three kids, following Chicago sports, enjoying ethnic cooking, and serving as a school board member for Norridge School District 80.

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Correlation Coefficient: A Tool for Diversification

Correlation coefficients can help investors determine whether their portfolios are adequately diversified. Learn how you can use this technical tool.

| BY Adriana Reyneri

Investors seeking greater diversity can use a technical tool called a correlation coefficient to get a better idea of whether their portfolios are truly diversified.

Diversity ranks as one of the top two investment concerns among affluent investors, according to a new Millionaire Corner study, but many investors – including those who lost 40 percent of their wealth during the financial crisis – are often shocked to learn their portfolios aren’t as diversified as they believed them to be.

A properly balanced portfolio minimizes risks while maximizing returns because some holdings will rally while others decline. While diversification - one of the underlying tenets of modern portfolio theory – works in theory, it often breaks down in execution. Investors seeking a more accurate measure of diversification can look at the correlation coefficient of various financial products.

“Correlation coefficents? What on earth does this have to do with creating a diversified portfolio?” asks Jeremy Vohwinkle of Generation X Finance. “If this sounds foreign or complex to you, don’t be alarmed. It isn’t as scary as it sounds.”

A correlation coefficient, says Vohwinkle, is “just a fancy way of saying” how closely two different types of investments will behave relative to each other. Possible correlation values range from -1.00 to 1.00 with a value of 1 representing a perfect correlation. If investment A and investment B have a correlation of 1, they would perform identically, explains Vohwinkle, adding “The farther from a +1 correlation two investments are, the more diversification you’ll realize by holding those two investments.”

Investors many not realize that sub-classes of stocks and bonds are closely correlated, said Vohwinkle, so that an investor with exposure to large-cap stocks would gain little diversification by adding mid-cap stocks to his or her portfolio. The same is true for an investor with government bonds who adds corporate bonds to a portfolio. According to Vohwinkle, just because an investor holds a “bunch of funds” doesn’t mean he or she is diversified.

“An investors who holds a portfolio with low-correlating assets has the opportunity to benefit from returns with less risk,” according to an archive issue of the CPA Journal. “Low-correlation investing can draw on a richer universe of investing options than stocks and bonds.”

According to the Oblivious Investor, while negative and zero correlations to the stock market are rare, investors can look for a low positive correlation coefficient to stocks.