Protecting Portfolios Using Correlation Diversification

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.

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 own 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.

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 totally 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. In fact, 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 totally 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.

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. (For more on macroeconomics, see "Macroeconomic Analysis.")

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.

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.

One stray bullet may not be enough to kill a portfolio of uncorrelated assets, but when the entire financial market is facing 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.

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 exposure that is many times more than your own 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 really 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.

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 a 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.