Episode 18: Correlation Obessession

In episodes 16 and 17 on the Wilson Wealth Management YouTube channel, we looked at diversification. How properly utilizing asset correlations can improve portfolio diversification and better manage investment risk in a portfolio.

Because of this, investors often obsess in finding the “perfect” correlations when adding assets into an existing portfolio.

In this episode, we consider the following questions:

“Should investors fixate on finding the optimal asset correlation when selecting new investments?”

Asset correlation is an important consideration. But investors cannot prioritize over the quality of the investment. The risk and expected return versus other investments being assessed. Nor its fit in the investor profile and target asset allocation, so financial objectives may be achieved.

“Why do investment advisors recommend low return bonds in a portfolio? Is this part of the whole diversification issue?”

Yes. Sometimes lower return asset classes can provide effective hedges against risks inherent in some higher risk classes. But it is about the relationship between two asset classes, not necessarily a function of just finding low risk, low return investments to add to the portfolio.

“I have the optimal asset correlations in my portfolio. Is it time to sit back, relax, and reap the benefits?”

No. Correlations between assets tend not to be stable. Over time, there may be permanent shifts. As with emerging markets and U.S. domestic equities. Or, the change may be temporary. As with domestic stocks and bonds over the decades. Correlation coefficients between investments should be monitored. If necessary, portfolio adjustments may be required to re-optimize the mix.

“I have read that roughly 30 stocks can achieve useful portfolio diversification. This mutual fund has 100 holdings. That should be ample for diversification, right?”

Maybe. Maybe not. It all comes down to the asset correlations.

For a little more detail in this area, please read “Asset Correlations in Action”, “Inter-Asset Correlations”, and “Shifting Diversification Benefits”.