Role of Correlation in Portfolio Diversification

Here are a few points highlighting the “Role of Correlation in Portfolio Diversification”:

Role of Correlation in Portfolio DiversificationPortfolio Diversification is about spreading your investments across asset classes. It’s the cheapest way to reduce the firm-related portfolio risk. Firm-related/Unsystematic risk arises when your portfolio is overweight on a particular industry/firm.

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Over-investment in particular industry/company can be risky. Unfavourable firm-related factors could jeopardised your portfolio returns. Similarly, any adverse environmental change affecting the particular industry may decimate your returns.

Diversification prevents you from keeping all your eggs in the same basket. It saves you from carrying a narrow set of investments. You know that at any given time not all funds perform well. If you have heavily invested in an inferior fund, you may lose out to poor performer.

Diversification can save a drain on portfolio returns. When your portfolio is well-diversified, portfolio returns remain in line with expectations. It’s like when one asset goes down, the others remain stable or may go up. It gives you downside protection.

Diversification can be looked upon as a defensive strategy. Even mutual funds operate on the same principle of diversification. By investing in multiple securities, the fund manager saves your portfolio from the impact of bad performers.

But you need to remember one point. You can diversify only unsystematic risks. Systematic/Market risks can’t be diversified. That’s why you receive a reward for assuming market risks. The higher the market risks assumed, the higher the returns earned.

Myths & Facts concerning Diversification

Diversification ain’t as easy to achieve as it looks. Investors may suffer from several myths as regards diversification.

These myths are busted with the help of facts as given below:

Myth 1: Investing in too many companies in the same sector/industry is diversification.

Fact 1: In reality, you have exposed your portfolio to sectoral risks. Failure or slump in that sector/industry may devastate the entire portfolio.

Myth 2: Investing in companies of particular market capitalization is diversification.

Fact 2: A portfolio which is overweight on small/mid caps is considered too risky. Small/mid cap companies are vulnerable to market shocks and surprises. These may beat the benchmark during bullish phases. But during bear runs, they would erode the portfolio returns uncontrollably. A small capital base prevents these from absorbing massive shocks.

Conversely, a portfolio which is overweight on large caps is also terrible. You may not beat the benchmark due to the limited growth potential of large caps.

Myth 3: Investing in a geographical region like Emerging Markets means diversification.

Fact 3: Geographically concentrating your investments is a risky proposition. Any political/economic adversity may reduce portfolio returns significantly.

Myth 4: Investing in companies of different market capitalization results in diversification.

Fact 4: Here also, your investments are concentrated in only single asset class i.e. equity. Diversification involves investments across different asset classes.

Myth 5: Investing in 10 to 20 different types of mutual funds is diversification. It doesn’t matter if they have identical portfolio composition.

Fact 5: You need to have fewer funds which have different portfolio composition. It aids in smooth tracking and management. It also prevents overlapping of portfolio holdings.

Myth 6: Investing in different asset classes leads to diversification. It doesn’t matter if they are positively correlated.

Fact 6: Although you have invested in different asset classes, your portfolio is still not diversified. It’s because if one goes down then, other also goes down like equity stocks and oil. As such unsystematic risk of the portfolio hasn’t reduced.

Also read: Risk vs volatility: here’s the difference

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Correlation and Portfolio Diversification: The interconnection

Correlation relates to movement of two or more asset returns in particular direction. It indicates the relationship between various asset classes in a portfolio. Two asset classes can be positively or negatively related. They can also be unrelated i.e. no correlation exists between them.

The value of correlation ranges from -1 to +1. -1 relates to the extreme negative correlation between assets. It means that when one asset price goes up, the other asset price goes down. +1 refers to perfect positive correlation. It means that both the asset prices move in the same direction. A correlation of zero indicates no relationship between the asset returns.

Correlation can be used to identify the type and degree of relationship between asset classes. However, it doesn’t specify the quantum of price movement of one asset in response to other. Moreover, it can’t be used to identify the cause and effect relationship between asset classes.

To minimise the portfolio risk, you need to construct a well-diversified portfolio. You need to work upon the correlation between the asset classes. You have to choose investments that are negatively correlated/uncorrelated.

For example: Suppose you are planning to invest in equity as one of the asset class. To counter the risk inherent in equity, you may add bonds as another asset class. It’s because the bonds are negatively correlated to equities.

Usually, when the stock market plunges, demand for bonds rise. Consequently, bond prices go up. The loss made in equity is compensated by gains made in bonds.

Similarly, equities can be combined with gold in the portfolio. Whenever there’s turmoil in the equity markets, investors rush to invest in gold.

In a nutshell, the lesser the correlation between assets, the higher the diversification attained.

Correlation & Portfolio Returns

Correlation between asset returns impacts portfolio returns significantly. In fact, an increase/decrease in asset correlation may decrease/increase the returns significantly.

This phenomenon can be illustrated using an example.

Table 1 shows asset returns of 3 types of asset classes. You may observe that Asset 1 & 2 are positively correlated to each other. When asset 1 moves up, the asset 2 also moves up.

Conversely, Asset 1 & 3 are negatively correlated with each other. When asset 1 moves up, the asset 2 moves down.

Role of Correlation in Portfolio Diversification

Let’s construct 2 portfolios. In Portfolio 1, you combine Asset 1 & 2. In Portfolio 2, you combine Asset 1 & 3. You contribute Rs 20000 to each of the portfolios. In each portfolio, the assets receive equal contributions i.e. each asset carries 50% weight.

Table 2 shows yearly portfolio returns of both the portfolios. You may calculate portfolio return (Rp) using the formula below:

Rp = {(w1r1 + w2r2)*Portfolio Value at beginning of the year} + Portfolio Value at beginning of the year

Where; w = weight of the security
r = yearly return on the security

Role of Correlation in Portfolio Diversification

The calculations reveal startling results. Portfolio 1 is more volatile than Portfolio 2. It falls vigorously from year 1 to year 2. Similarly, it rises strongly from year 2 to year 3. Conversely, Portfolio 2 keeps rising steadily from one year to the next year. Hence, lower the correlation, lower would be the portfolio risk.

In the last year, Portfolio 2 delivers higher value than Portfolio 1. It is the result of the negative correlation between Asset 1 & 3. Portfolio 1 delivers a lower final value because of the high correlation between asset returns.

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Final Words

Diversifying the portfolio is as important as the selection of good funds. Always go for negatively correlated assets in your portfolio. It would maximise return per unit of risk assumed.

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