In episode 17 on the Wilson Wealth Management YouTube channel, we continue our review of portfolio diversification. Our focus today is on asset correlations and the real-world correlation coefficients between different investments and asset classes. Specifically:
How does the asset correlation between investments impact portfolio risk and return?
We cover a simple real world example of correlation between two global oil companies. How, even in very similar businesses, there is still diversification potential to help manage overall portfolio risk. But by adding a dissimilar asset to the mix, especially one with a low to negative correlation coefficient, the diversification benefit greatly increases.
Investopedia talks about having a “wide variety of investments” to achieve proper portfolio diversification. Is there a right number and mix of assets?
In our example, we see that the right number of assets reflects the asset correlations between the investments. The lower the correlations between portfolio assets, the less number of different investments is needed to properly diversify. The higher the correlations, the more investments will be needed to achieve useful diversification. How you build your portfolio is more important than the sheer number of assets.
Investopedia added, “that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.” Is this true?
We also see in our example that diversification does not impact portfolio return. Overall portfolio return is simply a weighted average of all individual asset returns. Whereas, the overall portfolio risk does fall as new assets are added in the mix.
However, this latter effect may allow investors to invest in higher risk assets, with higher expected returns. So, while I would not agree with Investopedia’s statement from a completely factual perspective, I understand what they mean.
To read a little more on asset correlations, please refer to “Asset Correlations in Action”.
