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Protecting Portfolios Using Correlation

Diversification

By MANOJ SINGH | Updated Mar 23, 2018

Diversification naturally appeals to the risk-averse creature inside every investor. Betting all
your money on just one horse seems riskier than spreading out your bets on four different
horses – and it can be.

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But how do you choose those horses? You can use your intuition and randomly pick any four.
But that would be like playing a game of chance. Professional fund managers don't rely
merely on their intuition for picking a well-diversified portfolio. They use statistical
techniques for finding what are called "uncorrelated assets." Uncorrelated assets can help
you diversify your portfolio and manage risks – good news for investors who are wary of the
uncertainty in rolling dice.

But it's not perfect, either: diversifying your portfolio by picking up uncorrelated assets may
not always work. In this article, we show you what correlation is and explain how
uncorrelated assets work – and when they don't.

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A Game of Numbers
Correlation statistically measures the degree of relationship between two variables in terms
of a number that lies between +1 and -1. When it comes to diversified portfolios, correlation
represents the degree of relationship between the price movements of different assets
included in the portfolio. A correlation of +1 means that prices move in tandem; a correlation
of -1 means that prices move in opposite directions. A correlation of 0 means that the price
movements of assets are uncorrelated; in other words, the price movement of one asset has
no effect on the price movement of the other asset.

In actual practice, it's difficult to find a pair of assets that have a perfect positive correlation
of +1, a perfect negative correlation of -1 or even a perfect neutral correlation of 0. A
correlation between different pairs of assets could be any one of the numerous possibilities
lying between +1 and -1 (for example, +0.62 or -0.30). Each number thus tells you how far or
how close you are from that perfect 0 where two variables are uncorrelated. So, if the
correlation between Asset A and Asset B is 0.35 and the correlation between Asset A and
Asset C is 0.25, then you can say that Asset A is more correlated with Asset B than it is with
Asset C.

If two pairs of assets offer the same return at the same risk, choosing the pair that is less
correlated decreases the overall risk of the portfolio.

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All Assets Are Not Created Equal

Some plants thrive on snow-capped mountains, some grow in wild deserts, and some grow
in rain forests. Just as different weather affects different kinds of plants differently, different
macroeconomic factors affect different assets differently. 

Likewise, changes in the macroeconomic environment have different effects on different

assets. For instance, prices of financial assets (like stocks and bonds) and physical assets
(like gold), may move in opposite directions due to inflation. High inflation may lead to a rise
in gold prices, whereas it may lead to a fall in prices of financial assets.

Using a Correlation Matrix

Statisticians use price data to find out how the prices of two assets have moved in the past in
relation to each other. Each pair of assets is assigned a number that represents the degree of
correlation in their price movements. This number can be used for constructing what is
called a "correlation matrix" for different assets. A correlation matrix makes the task of
choosing different assets easier by presenting their correlation with each other in a tabular
form. Once you have the matrix, you can use it for choosing a wide variety of assets having
different correlations with each other.

While choosing assets for your portfolio, you have to choose from a wide range of
permutations and combinations. No matter how you play your hand in a portfolio of many
assets, some of the assets would be positively correlated, some would be negatively
correlated, and the correlation of the rest could be scattered around zero.

Start with broad categories (like stocks, bonds, government securities, real estate, etc.) and
then narrow down to subcategories (consumer goods, pharmaceuticals, energy, technology
and so on). Finally, choose the specific asset that you want to own. The aim of choosing
uncorrelated assets is to diversify your risks. Keeping uncorrelated assets ensures that your
entire portfolio is not killed by just one stray bullet.

Making Uncorrelated Assets Correlated

One stray bullet may not be enough to kill a portfolio of uncorrelated assets, but when the
entire financial market is facing an assault by weapons of financial mass destruction, then
even totally uncorrelated assets may perish together. Big financial downfalls caused by an
unholy alliance of financial innovations and leverage may bring assets of all kinds under the
same hammer. This is what happened during the near-collapse of the hedge fund Long-Term
Capital Management in 1998. It's also what happened during the subprime mortgage
meltdown in 2007-08.

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The lesson from those affairs now seems to be well taken: leverage – the amount of
borrowed money used to make an investment – cuts both ways. By using leverage, you can
take on the exposure that is many times more than your capital. The strategy of taking high
exposure by using borrowed money works perfectly well when you are on a winning streak.
You take home greater profit even after paying back the money that you owe. But the
problem with leverage is that it also enhances the potential of loss from an investment gone
wrong. You have to pay back the money that you owe from some other source.

When the price of one asset is collapsing, the level of leverage may force a trader to liquidate
even his good assets. When a trader is selling his good assets to cover his losses, he hardly
has time to distinguish between correlated and uncorrelated assets. He sells whatever is
there in his hands. During the cry of "sell, sell, sell," even the price of good assets may go
downhill. The situation becomes complicated when everybody is holding a similarly
diversified portfolio. The fall of one diversified portfolio could very well lead to the fall of
another diversified portfolio. So, big financial downfalls can put all assets in the same boat.

The Bottom Line

During hard economic times, uncorrelated assets may seem to have vanished, but
diversification still serves its purpose. Diversification may not provide complete insurance
against disaster, but it still retains its charm as protection against random events in the
market. Remember: Nothing short of a complete wipeout would kill all kinds of assets
together. In all other scenarios, while some assets perish faster than others, some do
manage to survive. If all assets went down the drain together, the financial market that we
see today would have been dead long ago.

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Related Terms
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Negative Correlation Definition

Negative correlation is a relationship between two variables in which one variable increases as the
other decreases, and vice versa. more

Correlation Coefficient Definition

The correlation coefficient is a statistical measure that calculates the strength of the relationship
between the relative movements of two variables. more

Mutual Fund Definition

A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other
securities, which is overseen by a professional money manager. more

Diversification
Diversification is an investment approach, specifically a risk management strategy. Following this
theory, a portfolio containing a variety of assets poses less risk and ultimately yields higher returns
than one holding just a few. more

Risk
Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual
return will differ from the expected outcome or return. more

Trading Plan Definition and Uses

A trading plan is a systematic method for identifying and trading securities that takes into
consideration a number of variables including time, risk, and the investor’s objectives. more

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