Diversification is an often-used buzzword in portfolio planning, but what does it really mean?
Are you diversified if you own a lot of stocks? Not if they are all, say, pharma stocks. Are you diversified if you own many mutual funds from various fund houses? Not if they are all mid-cap funds. If each component of a portfolio does the same thing, then the portfolio is no stronger than any one component.
The basic premise behind diversification is easy enough to understand: Spread your investments among assets that react differently to market events. The logic being that if something bad happens in the market, your investments don't all crash at the same time.
But how do you determine whether two assets will behave differently? How do you measure it?
That's where a statistical concept called correlation comes into play. Now the math is pretty complicated, but while it's not essential to memorize the formula, it's important to understand what correlation is since it often comes up in financial media or in discussions with your adviser.
Put simply, correlation is the degree to which the movements of two variables are associated with each other. In our case, that means the degree to which two investments have moved in tandem throughout their history in relation to their respective average.
It's expressed as a number between -1 and 1.
Correlation of 1
A correlation of 1 means the two investments have always moved in the same direction relative to their average return. Two diversified equity funds that both stay very close to the same benchmark, for example, would likely have a correlation near 1.
Note that a high correlation doesn't necessarily mean the two investments will have similar returns. It only means that when one performs better than its own average, the other one is probably doing so as well, and vice-versa.
Correlation of -1
On the other hand, a correlation of -1 means the exact opposite: when one investment goes up, the other one usually goes down.
While this may sound like the way to go for diversification purposes, having investments with high negative correlation is actually not good for investors because the gains of one will always be offset by the losses of the other, which pretty much guarantees that your overall returns will always be mediocre.
When building a portfolio, the ideal situation is finding investments that have very low correlations with each other, so that at any given time, a few of them will be losers, but most of them will be winners.
This post initially appeared on Morningstar’s Canada website but has been edited for an Indian audience.
