The turmoil in the markets in recent weeks has demonstrated the benefits of diversifying your assets. Stocks plunged, and bonds went higher in value. But how do you figure out how well your asset mix is diversified, and not too heavy in one area – like stocks?
Seasoned investors are used to spreading risk across multiple investments, such as stocks, bonds and commodities. Professionals, however, take it a step further: measuring so-called “correlation.” Without getting too technical, assets with a correlation of +1 move exactly the same in response to market developments.
That would be painful to a portfolio if bad news prompted all the assets to fall in tandem. Assets with a correlation of -1 move in opposite directions. This, too, poses problems by curbing a portfolio’s gains in response to good news.
The preferred correlation: anything less than 1. That’s when the benefits of diversification are more likely to kick in. For example, a portfolio with two securities with a correlation of 0.89 will move in the same direction. Both may fall in a market downturn, but one might not fall as far.
Remember that market risk is always present. It comes in all forms: accounting risk, business risk, country risk, default risk, financial risk, and government risk. What would have happened if you had invested solely in Greek bonds or only in Enron stock? Diversification only minimizes risk. Using statistical correlation allows you to refine your investment selections to lower risk even further.
Smart diversification should be the goal of every investor. Moreover, a widely followed investing concept called Modern Portfolio Theory holds that, the wider the diversification, the bigger the risk-adjusted returns. Clicking on this risk chart illustrates this point.
The more securities you add to a portfolio, the lower the risk – at least up to a certain point. Note that the curved line comes close, but never touches the market risk line. Of course, all bets are off, when it comes to systemic risk. Diversification offers little protection against a major calamity, such as a broad economic collapse.
Another caveat: Proper diversification limits a portfolio’s gains in a bull market. If the Standard & Poor’s 500 stock index increases 30% in any given year, don’t expect the same from a diversified portfolio. That’s tough to deal with when the stock market is surging. On the other hand, the same portfolio won’t likely mirror a 30% drop in the S&P 500 – a welcome tradeoff for many investors.
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Sterling Raskie, CFP, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is an adjunct professor teaching courses in math, finance, insurance and investments. His blog is Getting Your Financial Ducks in a Row, where he writes regularly about investments, retirement savings and financial planning.
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