Diversification & Correlation

Diversification and correlation among asset classes are key concepts when it comes to controlling risk while maintaining the potential to achieve reasonable returns. These may seem like complicated terms but they are simply meant to describe whether your investments complement one another or mimic one another.

Portfolios that lack true diversification are typically more volatile and volatility is a measure of risk.

Many investors understand the concept of diversification but lack the ability to measure it. Others may be aware of the terminology but don’t fully grasp what it means when it comes to choosing investments.

In this section, I describe proper portfolio diversification and describe how correlation is used to measure the level of diversification. These are tools used by institutional investors and pension plans.

You should use them too.

If, after reading this section, the concepts are somewhat unclear, seek the advice of a financial advisor. But before taking any advice, ensure that the advisor understands the correlation among asset classes and can explain it in simple terms.

First things first

Before you can build a diversified investment portfolio you need to understand the investments that you have to work with. Venturing into the investment world can be like walking into a supermarket without a shopping list. There is so much to choose from. The question is; where to begin?

Just as the grocery shopper needs to choose a variety of foods to create a balanced, healthy diet, investors need variety in their portfolios. A diet of steak and nothing else may be appealing to some but problems would soon emerge. The same applies to an investment portfolio. An unhealthy situation will eventually arise in a portfolio that consists of nothing but equities, for example.

Going back to a balanced diet; the Canada Food Guide has six broad categories or groups of food.

These groups include fruits and vegetables, oils and fats, grain, milk, meat and beverages. Each category contributes to the health and well-being of the individual. At the same time, different people require different diets. An infant, a teenager and a retiree will all need something from each group but in different proportions.

Within each group, specific choices can be made but each group should be included.

The same approach can be applied to building an investment portfolio.

There are several broad categories of investments that are referred to as asset classes. Each asset class should provide a different element to the investment portfolio and contribute to its overall health. It is also important to note that within each asset class there can be good and bad investments.

Investors often jump over the asset allocation process and immediately want to start making individual investment choices. In this situation entire asset classes can be ignored, leading to an unbalanced portfolio that is hazardous to your financial well-being.

Six asset classes

 There is a lot of discussion about what the different categories or groups should be but an argument can be made for six separate asset classes or categories. These asset classes include:

  • cash
  • fixed income
  • preferred shares
  • equities
  • real estate
  • precious metals

Some investors may have only one or two asset classes among their investments, while others may have all six. It is important to understand the basic characteristics of each.

Why only six asset classes?

Some publications propose as many as 15 asset classes or more. Within the equity markets, for example, they will separate Canadian equities, US equities and international equities into their own distinct asset classes. I believe it is a false classification.

All companies are trying to earn profits on their operations and grow in value, regardless of whether they operate in Canada, the United States, Europe, Asia or South America. Many Canadian mining companies have significant operations in other countries; should they be classified as Canadian companies or as international companies? Separating companies into different asset classes on the basis of where their head office is located doesn’t make sense.

Looking at it in another way, ask yourself whether US gold mining giant Newmont Mining is more closely related to Canadian gold mining giant Barrick Gold or to Apple? Newmont and Apple are both US companies, while Newmont and Barrick are both gold mining companies.

Yet some would put Newmont Mining in the same asset class as Apple (U.S. equities) but not in the same asset class as Barrick Gold. The truth is that they all belong in the same asset class and that asset class is ‘equities’.

Similar classifications are made in the fixed income (bond market) where government bonds, corporate bonds, convertible bonds, foreign bonds and real return bonds are all assigned to different asset classes. While they may have different characteristics, they are all bonds.

The result is too many asset classes which are too much alike.

It is also important to note that within each asset class there can be various sectors with distinct features and characteristics. Equities, for example, can include mining, financial services and technology companies. As mentioned, fixed income can include corporate, real return and convertible bonds. Real estate investment trusts can include office buildings, shopping centres and residential rental properties.

The following charts illustrate the various asset classes and some of the sectors within each.

 <Charts> 

As you can see, diversification is first achieved at the asset class level and further diversification can then be achieved at the sector level. A well-constructed portfolio will take both levels of diversification into consideration.

Individual investments are then made within each sector. Unfortunately, many investors immediately begin choosing individual investments without considering asset classes and sectors.

  

Mutual Funds, Segregated Funds & Exchange Traded Funds

Contrary to what some may believe, mutual funds, segregated funds and exchange traded funds are not asset classes. When investors want to participate in a market they can choose an individual investment, such as a particular stock or bond. Alternatively, they can choose to purchase a basket of investments, such as a mutual fund, segregated fund or exchange traded fund (ETF).

If the basket contains nothing but equities, that particular mutual fund would fall into the equity asset class; if it contained nothing but bonds, it would fall into the fixed income asset class. The same applies to segregated funds and exchange traded funds.

These three investment vehicles allow investors to hold a large number of investments all wrapped into a neat package. They will be discussed in more detail later in this section.

What is diversification?

 One of the goals of holding a variety of asset classes is to achieve diversification.

When financial advisors talk about diversification they are really talking about how investments or asset classes complement one another. There are times when investors believe they have a diversified portfolio when in reality it is not. A collection of a number of different mutual funds, for example, does not guarantee diversification.

If two investments in a portfolio are acting in exactly the same manner, there is little point in holding both of them. It is far more effective to replace one of the two with an investment that complements the other.

A hypothetical example would be a portfolio that holds ABC Canadian Equity Mutual Fund and XYZ Canadian Equity Mutual Fund. Generally speaking, they both go up and down with the Canadian stock market. At times one will outperform the other but the difference is negligible. The performance of one mimics the performance of the other.

A second portfolio might hold the same ABC Canadian Equity Mutual Fund as the first but also have an equal amount invested in the ABC Corporate Bond Fund. These two investments act differently to changes in the economic environment and it will be more common for one to show strong performance when the other is struggling. The performance of one complements the performance of the other.

In the first instance the portfolio will lack diversification, while in the second instance a basic level diversification is achieved by holding complementary investments.

Definition of correlation

How can you determine whether two investments or assets simply mimic one another or whether they complement one another? The measurement used to determine the relationship between two investments is known as correlation.

If two investments move in exactly the same direction, at exactly the same time and at exactly the same rate, their correlation is “1 to 1” (commonly referred to as a correlation of one)

If two investments move in exactly the opposite direction, at exactly the same time and at exactly the same rate, their correlation is “1 to -1” (commonly referred to as a correlation of minus one).

All correlations fall between plus one and minus one. (Sometimes correlations are defined in terms of percentage. In that case all correlations fall between 100% and -100%.)

Two investments can have a correlation of zero. It simply means that you cannot predict the return on one investment by the return on the other. Sometimes they will move in the same direction and sometimes they will move in opposite directions.

Low correlations and zero correlations indicate proper diversification. Correlations that are skewed to high positive numbers, closer to plus one, result in abnormally volatile portfolios. Correlations that are skewed to high negative numbers, closer to minus one, result in portfolios with lower returns.

The goal is to have a combination of assets that have low correlations to one another. In that way they are more apt to complement one another rather than mimic one another. It doesn’t matter whether this low correlation is negative or positive as long as it is low.

It is important to remember that correlation measures the relationship between two investments and not the performance of those investments.

While the correlation between two assets will vary over time, it is still a good tool for trying to minimize volatility. And that is the whole purpose of diversification.

Diversification and volatility

It is important to find the middle ground where you get reasonable returns with reasonable volatility from your investment choices. It can seem like advanced math but the principles are relatively simple.

Financial advisors have access to software which illustrates the correlation among a wide variety of different investments. While not every investment can be included in this analysis, a great many can, and this provides the investor with a feel for the level of diversification in their portfolio. It is certainly better than making random investment choices in the hope that they provide diversification.

Canadian equities, US equities and international equities are often classified as separate asset classes but when you look at the correlation numbers, it can be surprising how little value is added by simply adding equities based on the geographic location of their head office is improper diversification.

As mentioned earlier, if two investments simply mimic the performance of one another, you don’t need both of them. You would be far better off switching one of them to an investment that complements the other. Then  you would be far more diversified and your portfolio should have a better risk/return profile.

While that comment may seem repetitive it cannot be stressed enough.

Most people measure their portfolio simply by the rate of return it achieves but more are now starting to pay attention to volatility. It is important to include both measures when you are evaluating your portfolio.

Diversification within asset classes

 While diversification among asset classes is important, so is diversification within asset classes.

Diversifying between stocks and bonds is one level of diversification but within each of those asset classes you can add another level of diversification. Bank stocks act differently from energy stocks and real return bonds act differently from corporate bonds.

The process is not about trying to guess which will be the best asset class or the best investment within an asset class; it is about ensuring that you have the appropriate allocation among those asset classes and among the various investments within each asset class.

Proper diversification reduces volatility. The problem is that many investors thought they were diversified when they weren’t. Correlation helps them to measure that diversification and squeeze out volatility. Of course, the final goal is to maximize returns for the level of risk that is suitable to the client, so it does take a bit of mixing and matching to eventually come up with the ideal asset allocation.

 Notes:

  • Asset classes are broad categories of investments.
  • Six broad categories include cash, fixed income, preferred shares, equities (common shares), real estate and precious metals.
  • Sectors are sub-categories that may exist within each asset class.
  • Mutual funds, segregated funds and exchange traded funds are not asset classes.
  • Diversification refers to investments that complement one another.
  • Correlation is a statistic that allows us to measure diversification.
  • All correlations fall between -1.0 and +1.0.
  • Correlations closer to +1.0 indicate lack of diversification that may result in increased volatility
  • Correlations closer to -1.0 indicate over-diversification to the extent that potential returns are diminished.

NEXT: Investment Planning - Asset Classes

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