7 Diversification

Now that you understand the pitfalls of risk and the goal of reward, it is time to dig a little deeper into another important element of your portfolio: diversification. Diversification, in the investment world, simply means owning assets that are independent of one another. There is a metric used to measure this independence, known as correlation. Two investments that are highly correlated will rise and fall in tandem. Correlation is measured on a scale of -1 to 1, with 1 being a perfect positive correlation. Two assets with a perfect positive correlation of 1 would rise by the same amount and fall by the same amount in any given swing. If asset A and asset B have a 1 correlation, and asset A rises 10%, asset B will also rise 10%. There are so many assets and so many price swings in liquid markets that millions of correlations exist, many of them changing over time. This is the extent we need to know for now, but those interested in deeper portfolio analysis or studying finance can find a wealth of information on the topic online, in books, in lectures, and in peer-reviewed examinations and studies.

Correlation is an important part of the bigger topic of diversification, and in order to achieve diversification, we need to own some non-correlated assets. Using our previous example of asset A and asset B, which have a positive 1 correlation, there would be no use having both in a portfolio. If they are perfectly correlated, their returns will be the same, so there is no point in having both. This would be like owning two of the same iPhones or cars. To do everything and be most effective, you can’t just have iPhones or cars; you need a variety of functioning tools in your life. Portfolio construction is no different. It is best to have a multitude of different assets to help your portfolio achieve success.

When we say uncorrelated, what does that mean? Historically speaking, assets in different asset classes are good diversifiers. Asset classes are the different types of assets we’ve been discussing this whole time. Stocks, bonds, real estate, gold, commodities, and cryptocurrencies are all unique asset classes. These asset classes do not have perfect correlations with one another. Some aren’t correlated at all. By buying assets from different asset classes we can reduce the total volatility of our portfolio while making sure we receive returns from as many different sources as possible. Essentially, we are reducing risk while increasing possible rewards. Owning more stocks will not necessarily make your portfolio of stocks do any better. Most stocks tend to move in the same direction as the broad market. However, adding bonds to this portfolio can protect you from the downsides of a bad stock day. All the asset classes we have talked about so far are relatively uncorrelated, and should therefore be included in every portfolio in order to minimize risk and maximize return. Below is what is called a correlation matrix, showing the correlations of each asset class in Ava’s portfolio.

In practicality, achieving a sub-zero correlation is extremely rare, as most assets are correlated to some degree. Given the tendency for asset prices to go up, they naturally become correlated. Looking at our example matrix, the most correlated of Ava’s assets are the Total Stock Market Index and the Real Estate Index. The correlation between these two is .74, a relatively strong, positive correlation. Looking at the other assets, we can begin to see these correlations deteriorate, some as low as .10 or even 0. These all add to the diversification impact on her portfolio. By owning many different assets, she has put her eggs in multiple baskets, mitigating some of her potential losses.