How Does Correlation Influence Portfolio Diversification?

The aim of portfolio diversification is to reduce the risk which is inherent in owning individual securities. The investment specific risk is dependent upon the degree of correlation between movements in different holdings within the portfolio.

For example, if an investor has experience of banking and is, relatively speaking, an expert on banking subjects, it would make sense to be invested in that sector. However, if our private investor only held investment positions in banking companies and they were all in the same market (eg the US or UK) there would actually be very high risks associated with these investments. It is reasonable to expect most or all companies in a sector to move in the same directions, broadly in line with each other.

Such an example would be called Positive Correlation. this means that the profits, fortunes and prices of companies move up and down together. They will probably be impacted by the same or similar events.

However, if the fortunes and prices of companies move in different directions in reaction to the same news, they show a Negative Correlation. An often used example is to think of a shop near a beach selling goods to tourists. If it is sunny they sell ice cream. If it rains they sell umbrellas.

If many such companies can be held together, a large degree of portfolio diversification has probably been achieved.

There are some companies whose values and profits show no relation whatsoever to each other. These can be described as having No Correlation.

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The most effective portfolio diversification will come from making investments that show negative correlation to each other. However, simply by investing in companies who show returns that are not correlated perfectly to each other, the risk in the portfolio will be lower than the associated risk of any individual stock.

There is a limit to how many investments need to be held to reduce risk. Many studies have shown that an ideal number is between 15 and 20 holdings. Beyond this number, portfolio diversification does not appear to reduce the risk any further. Any further risk is likely to be market risk and cannot be removed by simply adding more holdings.

Diversified compared to what?

The ability to safely reduce risk is one of the key reasons why asset allocation (information here) is so important for fund managers. They are typically only looking for stock portfolio diversification (if they manage a mutual fund or unit trust). There is a very real limit to how much portfolio diversity is possible when there is a very specific benchmark to follow and be measured against.

In contrast to this, a general pension fund manager will typically have a much broader remit. With this goes some element of specialisation and market knowledge (who can really be an expert in 800 holdings?) but it does enable a much more balanced portfolio that includes government and corporate bonds and perhaps even some commercial property fund holdings. Their extra reach is simply due to the nature of their job - people do not invest in a pension to take risks! We invest in pensions to ensure that we have something waiting for us when we get old.

What is interesting is that - as mentioned above - there are many theories about how many holdings make a portfolio diversified, yet no pension fund can operate within those guidelines. Pension funds are sold as being diversified, which they clearly are, but they have so many holdings that they are often very closely correlated to the actual market.

Then at the very edge of the investment world (in terms of risks) are hedge funds. They have terms of reference that lay out their potential investment options, but generally they are quite broad. Since it is the job of a hedge fund manager to take but closely manage risks, they will be operating at the cutting edge of modern portfolio theory. For us mere mortals, the level of portfolio analysis and models they use will be quite mind bending.

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In contrast, for private investors this is tricky topic. Most of us do not have the required net worth or liquid assets to allow us to practice good portfolio management. For example, ownership of just one residential property - even to live in - is likely to throw every mathematical forumla into chaos simply because it will represent much too large a portion of our holdings. We also do not have the required software or analysis techniques to mimic the work of a Wall Street investment bank.

Near or far?

Additionally, such a holding offers little portfolio diversity. Often, if there is a recession or economic slowdown, most asset classes are impacted in some way. This means that the value of the property is likely to fall at the same time as the equity holdings fall and companies start making redundancies. These things are all inter-related.

This means that for true portfolio diversity there needs to be some holdings in a range of asset classes that are denominated in a range of currencies. Whilst this reduction in risk level for the portfolio is useful, the risk of holding the individual assets is almost certainly increased. This is because the further one strays from home, the less one is likely to know about an opportunity. Warren Buffett is the king of this type of thinking - he describes a circle of competence (information here) beyond which investors should not stray.

Buffett takes this concept further though. He also applies it to types of businesses that he does not feel confident he knows enough about. This is never mentioned, but it is a safe bet that someone as competitive as he is probably spends a substantial amount of time trying to expand his knowledge of different sectors.

Easy does it

All this can be quite a lot to take on for a private investor. It might be that passive investment (information here) is a better choice and simply using one or a few funds managed by investment titans such as Vanguard or Fidelity is an easier and more sensible solution.

If this is the case, for your own sanity, try to ignore investment returns as long as they are positive. Having had substantial experience working directly with individual clients, your author has had first hand experience of the impact that annual returns have on the human mind.

In other words, when selecting a fund, choose one (or more) that you feel comfortable with and whose style you think you understand. Then be happy when it does what you hoped it would. Far too many people get hung up comparing their returns with other funds that have very different risk profiles that they would never have actually selected. If you wanted low risk and invested in a bond fund, don't be unhappy that the "emerging markets small mining companies" fund performed much better. It sounds silly, but many people think this way.

It is this sort of thinking that leads too many people to chase returns and take on far more risk than is appropriate for them. Usually they do it without really understanding the potential pitfalls: what happens if they all drop simultaneously and your savings are substantially reduced? Always do your best to be low beta (information here) and ensure that only a small proportion of your money is used in higher risk investments (in or out of the stock market).

For more information about this important topic, we can recommend visiting here and here.