by WWM | Jun 17, 2020 | Diversification
Is your investment fund as diversified as you think it is?
Morningstar Canada considers this question in, “Is Your ETF Actually Diversified?”. And yes, the same question applies to mutual funds and other investment products.
The article does a good job of analyzing this issue. The focus being on how the method of index weighting can skew sector diversification. Worth a read.
But there are other lessons contained within, which are not considered by Morningstar.
Today I want to address how market weighting an index may distort sector diversification. And, more importantly, how to reduce this risk. We will cover other lessons in subsequent posts.
Index Weightings
Market indices (and related investment funds) may be created in different manners.
The two most common are market capitalization weighted and equal weighted. You may also occasionally see factor weighting and price weighting. But we will just look at the most common weightings.
Market weighted indices are created based on relative market capitalization of the holdings. If we use the S&P 500 as an example, behemoths like Microsoft, Apple, Amazon, and Google dominate based on their sheer size. While still large companies, relatively smaller stocks like Union Pacific, Danaher, and NextEra have minimal weightings.
Equally weighted indices do not factor in market capitalization. Microsoft is included in equal amount as Union Pacific. 500 companies in the index. Each carries 0.2% weight.
Index Investing May Not Provide The Diversification You Assume
The focus of the article is on how market weighted indices overweight certain industry sectors. This is true. Good to understand. I am just not sure it is that crucial for investors.
As the article points out, which overall market (e.g., country) the index covers will pinpoint the potentially over (or under) weighted sectors. What do I mean?
The iShares Core S&P 500 ETF (IVV) is a market weighted index proxy. Given the size of Microsoft, Apple, Google, Amazon, and Facebook, it is unsurprising to see that Technology is by far the largest market weighted S&P 500 sector at 26.7%. Trailing this is Health Care (14.4%), Communication (10.8%), Consumer Discretionary (10.7%), Financials (10.6%), and Industrials (8.0%).
If we compare that to Invesco’s S&P 500 Equal Weight ETF (RSP), Technology falls to second spot at 14.3% of the fund. Instead, in equal weighting, Industrials actually is the largest sector at 14.8%. A substantial redistribution versus the same companies under market cap weighting.
That is Morningstar’s point. By market weighting the S&P 500, you end up with an overweighting in Technology. This can negatively impact portfolio diversification. True.
Depending on how you calculate, your index may change the relative exposure to market sectors. However, changing relative sector weights by equal weighting, may or may not increase diversification. It depends, at least to me, on many other factors. Not simply weighting.
As well, should Union Pacific or NextEra carry the same weight in an index as Apple or Amazon? Does equal weighting better represent the large cap US stock market? I would argue that market weighting better reflects US equity reality. But your own mileage may vary.
Global Diversification
Part of the reason investors should diversify globally is to smooth out potential sector over-weightings in market indices. Different countries have different areas of dominance. By investing across markets, you can equal out your sector exposure and keep that diversification intact.
We saw in the S&P 500, that Technology dominates. But that is the US market.
In Canada, Financials (33%) rule the TSX Composite, with Basic Materials (14%), Oil and Gas (14%), and Industrials (11%) following. In Canada, Technology is only fifth, at 10%.
In Europe, consider the index fund, iShares Core MSCI Europe ETF (IEUR). Its top sectors are Healthcare (16%), Financials (15%), Consumer Staples (14%), and Industrials (14%). Technology is ranked seventh, at 7%.
In China, index fund iShares MSCI China ETF (MCHI) largest sector exposure is in Consumer Discretionary (27%), Communication (22%), and Financials (19%). Technology ranks seventh at 4%.
Canada offers significant Oil and Gas exposure versus relatively little in Europe or China. In turn, Europe is heavy in Healthcare, which is not a major sector in Canada nor China. And in China, Consumer Discretionary is a big sector. In Canada and Europe, much less so.
By investing in different geographical markets, your relative exposure to specific sectors changes. As well, you can allocate more to sectors or markets you think have upside. Whether that be overweighting a specific country index or in adding niche funds to your portfolio.
For example, if you are worried about not having enough Technology in your Canadian equity fund, you can add iShares S&P/TSX Capped Information Technology Index ETF (XIT) to complement your TSX Composite fund.
With so many ways to offset sector skewing, the concerns raised in the Morningstar article become less an issue.
Market Cap and Style Diversification
The same argument can be made for investing across different market capitalization indices (e.g., mega, large, mid, small, micro) or style (e.g., Value, Growth).
In the US equity market, mega cap companies (capitalization typically over USD 200 billion) dominate the S&P 500 index. The Apples, Amazons, Facebooks, Microsofts, Googles of the equity world.
The Russell 2000 tracks US small cap companies (capitalization typically USD 250 million to 2 billion). In this market segment, Healthcare (21.5%), Industrials (15.2%), and Financials (15.1%) exceed Technology (15.0%) for sector exposure. A marked difference from the S&P 500 breakdown.
With style, let us compare two mid-cap indices (capitalization typically USD 2 and 10 billion). We will use iShares S&P Mid-Cap 400 Value ETF (IJJ) and iShares S&P Mid-Cap 400 Growth ETF (IJK).
IJJ’s top five sector weights are Financials (23.1%), Industrials (13.7%), Consumer Discretionary (12.4%), Real Estate (11.7%), and Technology (10.0%).
IJK’s top five sector weights are Technology (22.0%), Industrials (17.9%), Consumer Discretionary (14.9%), Healthcare (14.5%), Real Estate (9.1%).
First, we see variation in sector weightings between US market equities of small, mid, or mega capitalization. Second, even within the US mid-cap market, there are different sector weightings based on whether the companies are Value or Growth stocks. Both findings make sense and are expected. And a reason to diversify into asset subclasses.
It is useful to understand the differences between market and equal weighted indices. And that market weighting can skew sector allocations. That said, there are many ways to adjust sector weights on your own. Then create the allocation you desire.
by WWM | Apr 10, 2019 | Diversification
Before we move on to the next phase on investing, I want to highlight asset correlations and expand slightly from comments I made in a fixed income post. Not the easiest topic to explain nor understand. But critical in understanding why diversification plays such an important role in building a proper investment portfolio .
Diversification and Asset Correlations
We covered Diversification and Asset Correlations previously.
Correlation is a statistical measure of how one asset moves in relation to a second asset.
Many variables impact how two assets react to each other. In the linked article, I used two Starbucks as an example. At a very close level, with only a few variables, there are still some differences in operations and performance. The greater the number of variables, the greater the differences in returns of each Starbucks location.
It is an identical relationship between bankable assets, such as equities. Two Western Canadian operating oil companies’s shares will be impacted by oil prices, taxes, the economy, and so on. But differ based on their management, the ability to find productive plays, etc. This will differ too versus an oil company operating in Iraq or Texas. Because there are more variables and the impact on a Calgary versus Iraqi oil company will be different to some extent.
Correlation Coefficient
The correlation coefficient measures how closely two assets move in lockstep.
Perfect movement together is 1.0. Perfect movement in opposite directions is -1.0. No correlation between the two assets would be 0.0. Assets within a specific asset class tend to be relatively highly correlated to each other.
This figure is important when calculating portfolio risk. There is no impact on return.
If you review, Asset Correlations in Action, you can see the mechanics of how adding any asset to your portfolio that is not perfectly, positively correlated, will reduce overall portfolio risk. The level of risk reduction will be based on the correlation between the assets, as well as the quantity added.
If you have a $100,000 portfolio and add an asset with with a correlation coefficient of -0.60, you will get some nice risk impact. But if you only add $1000 of that asset, the impact is negligible. Whereas, adding $75,000 in an asset with 0.50 will actually be preferable due to the amount.
Also, while you want to look for lower correlated assets to add to your portfolio, do not forget about return. Many assets that have low correlations to stocks, for example, may also offer lower expected returns. The correlation coefficient does not reduce returns, as it does with risk. But you may suffer lower portfolio returns by adding lower return assets just to meet your goal of adding non-correlated assets to the mix.
But Do Not Exclude Lower Return Assets Outright
As I covered in Asset Allocation: Fixed Income (Part 1), that does not mean lower return fixed income should be totally excluded from one’s portfolio. Fixed income investments may provide diversification benefits with other asset classes.
Fixed income (currently) has a negative correlation to many equity subclasses. That means the assets move in relatively opposite directions. If equities fall in price, then bonds, even at lower rates, will do well. So, yes, bonds may have lower long-term expected returns than equities. But when equities experience bear markets, bonds provide a safe haven.
I say “currently”, as correlations are not stagnant. They can shift up or down (or reverse themselves) over time based on changing economic factors. Periodically review asset correlations within your portfolio to ensure they are still optimal.
For example, many years ago, emerging market equities offered excellent diversification to domestic stocks for Canadians or Americans. That is because, for many reasons, domestic companies tended to operate primarily in their own countries or regions. What was happening in Japan, Argentina, or Germany, had relatively little impact on a business serving the Mid-West US markets. But as international trade grew, the correlations also rose. Still diversification benefits to emerging markets, but less than in the past.
Going back to our Starbucks example. Starbucks began life in 1971. A single store in Seattle. In 1987, Starbucks finally expanded out of Seattle, to Vancouver and Chicago. What Australians or Swiss drank was of no concern. It was not until 1996 that Starbucks expanded outside the US, with a location in Tokyo. 25 years of revenues solely from North America. Yet by 2018, Starbucks had over 27,000 locations in 76 countries or territories. A good example of globalization and shrinking of borders business-wise. As the world changes, so too may inter-asset correlations.
Correlation of Fixed Income
Consider a few current inter-asset correlations, using data from Portfolio Visualizer as at March 15, 2019.
The current 10 year correlation between 20 Year U.S. Treasury Bonds (i.e., fixed income) and various traditional equities are: U.S. Large Cap Stocks −0.47; U.S. Mid Cap Stocks −0.46; U.S. Small Cap Stocks −0.45; International (excluding U.S) Stocks -0.43; Emerging Market Stocks -0.38.
As I wrote above, combining two assets with negative correlations is very beneficial in reducing portfolio risk. And any correlation below 1.0 (perfect positive correlation) improves overall portfolio efficiency. But the lower, all the way to -1.0 (perfect negative correlation), the better for diversification of portfolio risk.
Fixed income offers excellent diversification potential in an equity laden portfolio.
When we look at alternative asset classes, fixed income can also enhance diversification. Consider the latest 10 year correlation between 20 Year U.S. Treasury Bonds and: U.S. Real Estate −0.22; Commodities -0.22; Gold 0.17. Once again, fixed income can aid in portfolio diversification with alternative assets.
Do not forget that within the asset class itself, various subclasses may provide diversification benefits too. For example, the correlation between the 20 Year U.S. Treasury Bonds and U.S. Municipal Bonds is only 0.37. So there is still value in diversifying within the asset class.
Of course, you also need to factor in asset risk (standard deviation) and expected annual return in your portfolio calculations. Adding a high risk, low return asset to your portfolio simply because it has a low correlation may not be wise.
Note as well, going to my point on globalization impacting asset correlations. Today, emerging market equities have a very positive correlation of 0.83 to US domestic equities. 40 years ago that correlation was much lower, with much higher diversification impact. Be sure to monitor for changes in correlations over time.
Okay, enough on asset correlations. But important to understand when we begin building portfolios. Otherwise, the question is always, “Why would I ever want 3% bonds in my portfolio if stocks expect 8% annually?”
by WWM | Jun 7, 2017 | Diversification
Today we shall look at a few more areas of interest relating to diversification.
In An Introduction to Diversification, we saw that Investopedia recommends holding a “wide variety of investments” to benefit from diversification.
Further, that a diversified portfolio will generate “higher returns and pose a lower risk than any individual investment found within the portfolio”?
Is this true? What does it mean?
A Wide Variety of Investments?
The greater the number of investments in one’s portfolio, the greater the diversification.
This implies that you should have as many investments as possible in your portfolio.
However, the greater the number, the less the impact from any one additional investment.
If you have a single asset portfolio and add a second asset to the mix, there will be significant impact from the new asset. But if you have 1000 assets equally in your portfolio, the addition of one more will have minimal influence.
The “Ideal” Number of Investments
So what is the ideal number?
The optimal number of individual investments, excluding such things as funds, fluctuates slightly from study to study. Some claim that 20-30 proper investments will result in strong diversification. Other studies found that 15-20 stocks can provide adequate diversification to eliminate nonsystematic risk. Some studies even believe that the benefits of diversification are exhausted in portfolios with more than 15 investments.
As to what is the right number, I think it varies depending on the investor. If I got creative, I could probably build a portfolio of 10 or less assets that managed to diversify efficiently. Others might need 40 to properly diversify. It depends on one’s investment objectives, constraints, accumulated wealth, access to markets, economic conditions, etc., etc.
Asset Correlations are Key
The key to effective diversification is the correlation between the investments.
If you are comfortable investing in fine art within your investment portfolio, you may not require many assets to diversify. If you only want to invest in North American based public companies, you will require significantly more assets to diversify.
Regardless of the “right” number, you can see that it is not substantial. And by that, I mean less than 50 individual assets.
Less investments are also better for long term compounding. Buying and selling multiple investments results in transaction costs and potentially taxes payable on any gains. That negates the impact of compound returns.
Another factor to bear in mind is your opportunity cost (the cost of your time). Researching and monitoring 30-50 existing investments, plus potential assets, can require substantial time and energy. Unless your hobby is financial analysis (a fun hobby, I grant you), you probably do not want to spend your free time monitoring investments.
Higher Returns Through Diversification?
I have thought a bit more about the Investopedia statement. It is still inaccurate, but I think I can explain it.
I do not believe that you can get higher returns just by diversifying. As I explained previously, a portfolio’s expected return is simply the weighted average of every component’s expected return.
But diversification does allow the ability to add higher return assets to the portfolio to improve the overall expected return of the portfolio.
Say you have a two asset portfolio. Asset A has an expected return of 10.0% and a standard deviation of 5.0%. Investment B has a 14.0% expected return and a standard deviation of 8.0%. Your portfolio is 50% of each and the correlation between the two assets is 0.70.
Skipping the calculations, click here if you want to see the basic formulas, the portfolio has an expected return of 12.0% and a standard deviation of 6.0%. Note that we have already breached the Investopedia statement that a diversified portfolio will yield higher returns than any individual investments in the portfolio.
But we can get a nice increase in expected returns by adding a high risk investment to the mix. Let us add asset C with an expected return of 50.0%, but a standard deviation of 30.0%. Further the correlation between asset A is 0.60 and 0.90 with asset B.
The ABC portfolio will have an expected return of 24.6%, a huge increase from the 12.0% expected return of an AB portfolio. But again, the higher average is less than the return of asset C on its own.
So while you may be able to increase expected performance in a portfolio, it will never be greater than the return of all individual assets.
What about risk though?
Lower Risk Through Diversification?
As we saw with our correlation calculations, proper diversification will lower portfolio risk. Again, not necessarily lower than all individual assets though.
In our two asset AB portfolio, the standard deviation is 6.0%. Less than asset B’s 8.0% risk but more than asset A’s 5.0%.
Note that by combining two less than perfectly correlated assets, we reduce overall portfolio risk versus a weighted average calculation (in this case, 6.5%) as we calculated with expected return.
Now let us look at adding asset C to the risk calculation.
The standard deviation of ABC portfolio is 13.5%. Now the combined risk is higher than both A and B on their own and even the AB portfolio itself.
Like returns, Investopedia’s statement on lower risk is a tad faulty.
What Should Investopedia Have Stated?
I am not going to hammer Investopedia as they tend to do a good job. However, by keeping things brief and general, at times you do not get the optimal story. True with everyone, including me.
I might have looked at the impact of diversification on portfolio returns and risk.
For a given return level, proper diversification will reduce the portfolio risk.
Or for a given risk level, proper diversification will provide higher returns.
But that is for the portfolio as a whole, not compared to its individual investments.
Adding Assets to Reduce Portfolio Risk
For example, you have a single asset portfolio, asset X. Its expected return is 20.0% and its standard deviation is 10.0%. You like the return but are concerned about the amount of risk. You decide to add another asset in a 50% mix of the two assets and find two potential investments that both have 20.0% expected returns.
Investment Y has a standard deviation of 10.0%, the same as asset X. Asset Y has a 0.20 correlation to X.
Investment Z has a standard deviation of 7.0%, lower than X. Its correlation to X is 0.90.
An XY portfolio will have an expected return of 20.0%. But an XY standard deviation will only be 7.8%.
An XZ portfolio will also have an expected return of 20.0%. But the XZ standard deviation will be 8.3%.
Both portfolios are more efficient than holding asset X alone.
Note that XY is more efficient than XZ even though Y has a higher amount of risk than Z. That is because of the differences in correlations. The lower the inter-asset correlation, the greater the risk reduction impact.
The same may be said for someone wanting to enhance portfolio returns while keeping risk stable.
Adding Assets to Increase Portfolio Returns
You own asset X and are comfortable with portfolio risk of 10.0%. However, you would like to increase your potential returns. Perhaps you find investment option S with an expected return of 28.0%, a standard deviation of 13.0% and a correlation with X of 0.50.
In combining the two assets equally, the expected return of XS has increased to 24.0%, but the standard deviation remains the same at 10.0%.
Again, correlation plays a significant role in risk reduction. Had the correlations been 0.90 rather than 0.50, the standard deviation of XY would be 11.2%. For investment options with high correlations, you would need to accept lower risk-return profiles to equal the risk of X alone.
Okay, I hope that helps clarify diversification.
And I hope you can see how important asset correlations are in achieving proper portfolio diversification. It is so much less about the number of assets in your portfolio and so much more about the correlation between portfolio assets.
If not, do not worry. It is a rather complicated subject. I just want to lay the groundwork now for when we look at asset allocation and portfolio construction strategies.
I think we will move on to a discussion of investment returns next.
by WWM | Jun 1, 2017 | Diversification
Today we will look at an example of how asset correlations impact portfolio diversification.
Namely the impact on portfolio risk and expected returns.
Correlations in Action
Exxon Mobil is a multinational oil and gas publicly traded company. Let us pretend that your investment portfolio only holds shares in Exxon. A non-diversified portfolio.
The expected return of Exxon is 15% and the investment risk (i.e. standard deviation) is 10%.
You have read that diversifying your portfolio helps reduce portfolio risk. So you want to sell half your Exxon stock and invest the proceeds in another instrument.
From your research, you find two possible investment options.
Option one is shares of Chevron, another multinational oil and gas company. Option two is the Fine Art Fund; a mutual fund made up of fine art investments. Both have the same expected returns, 25%, and standard deviations, 20%.
If they both have the same risk-return profile, does it really matter which one you select?
Yes!
In many ways, Exxon and Chevron are the same company. They are in the same industries, operate in similar countries, and are affected by the changing price of oil and related commodities. One should expect their share prices to mirror each other to a great degree.
Their performance will not be exact due to company specific risks.
In 1989, faulty equipment, human error, and fatigued crew were factors in the crash of the Exxon Valdez in Alaska. A crash that caused many problems for Exxon.
In Ecuador (and other jurisdictions), Chevron is involved with the Ecuadorean government (and others) over environmental issues that may result in fines and costs to Chevron.
But for the most part though, in the absence of unique situations, the share prices of major oil companies generally move together up or down.
That is why I would anticipate the correlation between Exxon and Chevron being close to 1.0 (i.e. 100% positive). Not exactly 1.0, as the two companies operate in some different markets, have different product mixes, different management, etc.
I would expect over a long period for the two companies to track each other quite well in share price. Compare the five year performance between Exxon (stock symbol: XOM) and Chevron (stock symbol: CVX) – you can compare companies using Yahoo Finance Interactive Charts – and the similarities over time are striking.
But although they are close, they are not exact matches. That is good for diversification.
But not great.
The Importance of Correlations
Anytime the correlation between two assets is less than 1.0, there is an advantage in reducing overall risk by adding the new investment to one’s portfolio.
That is because of the portfolio risk-return calculations.
In (very) short, by adding assets that are not perfectly correlated to each other, one receives the cumulative impact of the expected returns, but only a reduced impact on portfolio risk.
I have re-read the Investopedia definition of diversification a few times.
I do not really understand what they mean when they state diversification will “yield higher returns and pose a lower risk than any individual investment found within the portfolio.”
I agree with the latter part of the statement, but have trouble with the first section.
Correlations and Portfolio Expected Return
While diversification allows you to invest in assets with high expected returns, diversification does not give the portfolio any magic bump.
In an investment portfolio, the expected return of the portfolio is simply the sum of each individual investments’ weighted averages in the portfolio.
For a simple, two asset portfolio:
ERp = (Wa)(ERa) + (Wb)(ERb)
Where:
ERp = Expected return of the portfolio
Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)
ERa = Expected return of investment “A” in the portfolio
In our example, the expected return of Exxon is 15% and 25% for Chevron. If you invest 50% of your portfolio in each asset, the portfolio’s expected return should be 20%.
ERp = .50(15) + .50(25) = 20%
Pretty easy.
Remember that expected returns are just weighted averages of all the individual investments.
Correlations between assets do not impact the expected returns of the portfolio.
Correlations and Portfolio Risk
However, it is not that simple a calculation for the risk of the portfolio.
You need to factor the assets’ correlations into the equation. In a two asset (A and B) portfolio:
℺²p = (W²a)(℺²a) + (W²b)(℺²b) + (2)(Wa)(Wb)(℺a)(℺b)(pab)
Where:
℺ = Standard deviation
Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)
pab = Correlation between investments “A” and “B”
The first part of the equation looks a lot like the expected return calculation. In that sense, there is a weighted average effect from risk.
But let us see how the second part of the equation alters the equation’s impact.
Diversification Impact of Strongly Correlated Assets
In our example, the standard deviation for Exxon was 10% and for Chevron 20%. Because the two companies are quite similar, I shall say that the correlation coefficient is 0.85. Not quite 1.0, but close.
If we crunch the numbers we see that the portfolio standard deviation is 14.49%. Slightly less than if we simply took the weighted average (15%) as we did with expected return.
The difference is due to the fact that the two assets are not perfectly correlated. However, because the correlation of 0.85 is very high, the reduction in risk is relatively small.
Diversification Impact of Weakly Correlated Assets
Now let’s consider our other potential investment; the Fine Art Fund. It had the same expected return (25%) and risk (20%) as Chevron. Therefore, we would expect an Exxon-Fine Art portfolio to yield the same expected return and risk as the Exxon-Chevron combination.
Actually, no we would not expect that in the slightest.
Here’s why.
In the real world, the correlation between fine art and oil companies is negligible. There is almost no correlation between the performance of Exxon and a bunch of paintings. Let us say the correlation between Exxon and the fund is 0.002.
Now for the numbers.
The expected return of a portfolio consisting of 50% Exxon and 50% Fine Art Fund would be 20%. The same as with the combined Exxon-Chevron portfolio.
This is because both Chevron and the Fine Art Fund have the same expected returns. And, as we saw above, expected return calculations are simply weighted averages of the portfolio’s individual investments.
But the portfolio risk is a different story.
If we crunch the numbers we see that the portfolio will have a risk of only 11.2%. Much less than a pure weighted average of 15% and significantly less than the Exxon-Chevron combination of 14.49%.
Yet the expected returns of both a portfolio of Exxon-Chevron or Exxon-Fine Art Fund are identical at 20%.
From a risk-return aspect, the Exxon-Fine Art Fund is the much better investment combination than Exxon-Chevron.
Why is Option Two Superior?
Because of the correlation between the assets.
Assets with high correlations receive some impact through diversification. But as you move toward a perfect correlation of 1.0, the risk reduction benefits from diversification lessen.
If you really want to reduce portfolio risk, you need to add assets that have low, or even negative, correlations to the assets already in the portfolio.
Investopedia states that diversification “mixes a wide variety of investments within a portfolio”.
True.
But to make it worthwhile, be certain you consider the correlations between assets as well as expected returns and risk levels in your investment selections. You want to add assets that are weakly correlated to your existing portfolio. Not simply a “wide variety of assets.”
The impact on your portfolio’s efficiency could be huge.
As for the optimal mix, there are many other variables that need consideration. We will look at them down the road in asset allocation and portfolio construction.
This sort of gets at the Investopedia claim about how diversification can “yield higher returns.” Say you find a weakly correlated asset that offers higher expected returns to add to your portfolio. You may be able to maintain your portfolio risk at its current level, yet get a bump by adding the potentially higher return asset. Poorly worded by Investopedia.
Next up, a few more thoughts on the benefits of diversification.
by WWM | May 24, 2017 | Diversification
In An Introduction to Diversification, we began our review of the subject.
Learning even a little about asset correlations is crucial to better understand why diversification is important in an investment portfolio.
Asset correlation is a relatively advanced topic. For some, that means I will not get into it as much as you would like. For others, your eyes may quickly glaze over in boredom.
Either way, I hope you gain some insight about correlation and how it can help you improve your investment results.
What is Asset Correlation?
Correlation is a statistical measure (no escaping the world of stats!) of how one asset moves in relation to a second asset.
With investment assets, risk factors can significantly affect performance. We looked at many of these variables in our discussions of nonsystematic and systematic risks. Government policies, inflation, interest rates, hurricanes, company management are a few examples.
The closer in characteristics two assets are, the more they will be affected by the same risk factors. The more divergent the assets, the less impact individual risk factors will have on each at the same time.
Let us use coffee shops to illustrate this point.
Two Starbucks franchises located on the same city block in New York are almost identical in nature. Same clients, same products, same impact from changes in coffee prices, and so on. There may be some minor differences, but not many.
If the city suffers an economic downturn, each shop should suffer equally. If Starbucks is investigated for selling coffee laced with carcinogens, business at both will fall.
Now compare a Starbucks with an Italian espresso shop on the same block.
Many of the same risk factors will be identical because of their physical proximity and product offering. If the local economy falters, both businesses may have difficulties. But if Starbucks is sued for potentially killing customers, Starbucks will suffer whereas there will be no negative impact on the espresso bar.
What about comparing two Starbucks? One in Los Angeles, one in Zurich.
Again, there are similarities between the two, but also large differences. If an earthquake in Los Angeles destroys every Starbucks in the city, there will be no problems for the Zurich franchise. If the Swiss economy struggles and customers look for more cost effective coffee options, that has no direct effect on business for a Starbucks in California.
We could look at many more combinations, but you get the idea.
Correlations and Investing
Like Starbucks’ franchises, some investments share many of the same traits and risk factors. Others have little in common. Some even react in opposite directions to the same risks.
How an investment moves or performs relative to another asset is its correlation.
And this correlation is the reason you want to hold a “wide variety of investments” (per Investopedia) in your portfolio.
When two investments are positively correlated, their performance will move in the same direction. Like two Starbucks on the same street.
When two investments are negatively correlated, if one asset outperforms its expected results, the other will underperform. Perhaps like a pawn shop on the same city street as the Starbucks.
When the economy is great, it’s frappuccinos for everyone. People are making money and not needing to hock their assets. The pawn shop is a lonely place.
But when bad times hit and people become unemployed, there is less money available for a premium priced coffee. Starbucks struggles and may incur losses. Meanwhile, the cobwebs have been cleared off the pawn shop cash register and business is booming. At least until the economy recovers and the Starbucks’ baristas are back at work.
If the movements of two assets are exactly identical, they are 100% positively correlated. If they move in exact opposite directions, they are 100% negatively correlated. If they have no relationship at all, the correlation is 0%.
In investing, correlations range from 1.00 (100% positive) to -1.00 (100% negative).
Most assets are positively correlated to varying degrees. In part this due to increasing globalization and far reaching risk factors that impact most assets. These include inflation, interest rates, government policies, and employment rates.
While most assets are positively correlated, few are perfectly correlated. That is, few assets have correlations of 1.0.
Consider the two Starbucks on the same street. As close in likeness as can be. However, one manager may be better than the other, resulting in customers buying more accessories. Or perhaps the baristas are better in the second shop. They are friendlier, faster, and serve better quality drinks. So although both shops have the same offering, customers over time may increasingly frequent the shop with better service.
Even in a small example like this, there are potential differences between almost identical businesses. This is equally true for investments. And, as we shall see below, these minor differences can play an important role in managing portfolio risk.
Correlations between two specific assets may change over time. As the characteristics and circumstances of the underlying investments shift, so too can the correlations.
Next up, a real life investment example of asset correlations in action.