Correlation vs Diversification

When it comes to investing, the term “diversification” is often thrown around like pixie dust. Many people believe that simply having a variety of funds in their portfolio means they are diversified and, therefore, protected against risk. However, true diversification goes much deeper and involves understanding the concept of correlation.

Imagine this: people often say, “Don’t put all your eggs in one basket.”

But if you have twelve different baskets and place them all in the back of the same pickup truck, what happens when the truck hits a bump?

More than likely, all the eggs will break, despite being in different baskets. This scenario illustrates high correlation—your investments may seem varied, but if they all react similarly to market changes, you are still at risk.

Correlation measures how different investments move in relation to one another. Investments with high correlation tend to react similarly under various market conditions.For instance, if you have multiple funds that all hold similar stocks, your portfolio might still be exposed to the same risks, even if the funds themselves are different.

Our portfolio managers work meticulously to understand and manage these correlations. Instead of just spreading investments across different funds, they focus on how these investments will perform under different market conditions.This approach ensures a balance that can weather various financial storms.

The 60/40 Portfolio – Is it Conservative?

A great example test of the 60/40 portfolio (60% stocks and 40% bonds) was in 2022. Many people believed they were diversified by holding both stocks and bonds, and that they were conservative (or safe as many would put it).However, when the Federal Reserve aggressively hiked interest rates, both stocks and bonds suffered. Those who had a traditional 60/40 portfolio, took a double-digit loss.

During that time, it was essential to hold specific types of stocks, like energy and healthcare stocks, which tend to perform well during inflationary periods.On the bond side, floating rate bonds and certain secured notes (or FIAs) were critical to maintaining stability. (read more about FIAs as an asset class here)

This kind of strategic diversification based on correlation analysis is what protects a portfolio against unexpected market shifts.

When we analyze clients’ portfolios, we often find that they hold multiple mutual funds that essentially contain the same underlying assets. This high correlation means they are not as diversified as they might think.It’s akin to driving a Chrysler and a Dodge—different names, but fundamentally the same.

Our goal in portfolio management is to ensure true diversification by selecting investments that are not only varied but also have low correlation with each other.

This way, we can better manage risk and improve the potential for stable returns across different market environments.

Diversification is more than just having a colorful pie chart of different funds. It involves a deep understanding of how various investments are correlated and ensuring that your portfolio can withstand different market scenarios.

By focusing on correlation, sector exposure, and strategic asset allocation, along with being agile to adjust to economic environments, we can build robust portfolios that truly diversify risk and enhance potential returns.

So, next time you think about diversification, remember to look beyond the surface and consider how your investments interact with each other.