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