Diversification and Correlation – How To Create a Well-Balanced Portfolio

by ifund · November 6, 2018

The examples of diversification and advice provided apply the best for conservative investors but knowing about asset correlations is really useful for every type of market participants such as traders and speculators.

Why diversify in the first place?

The primary aim of investing is to earn money. That means firstly focusing on avoiding negative returns, keeping funds safe and only then seeking for gain. Diversification is what helps to gain money with a low risk of losing.

It may seem we don‘t need diversification because it lowers return: „ If I chose an excellent stock why should I select other lower-return investments just to decrease my total return?“. In fact, there are several reasons why an investor needs properly diversified portfolio.

For instance, in a hypothetical scenario investor A has invested all of his free capital in a single company. The company is doing good job, they generate good profits, has strong fundamentals and seemingly no warning signs are present. It turns out that company‘s CEO is keen on gambling and he has accumulated a lot of debt. Even though the CEO‘s personal life is not connected to company‘s financial returns, the stock price drops.

Investor B likes cars and wants to invest into automotive manufacturing companies. He has done a better job than investor A in reducing risk by buying 5 stocks from the automotive sector. The companies are mainly selling petrol and diesel cars. Suddenly, EU imposes a ban on internal combustion vehicles, meaning a large portion of the companies‘ sales will be lost in a near future. This systematic risk affects the whole automotive sector and investor B loses because he has only diversified across stocks, but not different sectors. This example shows that simply investing in more financial assets does not mean better diversification if those assets are strongly related.

That is why textbooks, lecturers and online courses usually teach us to diversify our investment portfolio by choosing various unrelated assets. A portfolio of 60% stocks and 40% bonds is perceived as a well-diversified. One of the key ideas of Modern Portfolio Theory is picking assets with uncorrelated returns to reduce risk. This approach has served investors well for quite some time by helping to reach a better risk/reward ratio. Although today, 10 years after the global financial crisis, it is unclear if this idea still holds.

How assets correlate

Correlation is a statistical measure that shows how assets move in relation to each other. It is measured on a scale of -1 to +1. A perfect positive correlation between assets has a reading of +1 and means that their prices move at exactly the same magnitude (equal percentage moves) to the same direction. A perfect negative correlation has a reading of -1 and implies that assets move in opposite directions, while a zero correlation means no relationship at all. For instance, the US dollar and stock market index S&P 500 is a classic example of a negative correlation.

Image source: https://stockcharts.com/articles/dont_ignore_this_chart/2011/07/dollar-and-sp-500-continue-negative-correlation-uup-spx.html

Bonds and stocks

Bonds and stocks are another classic example of negatively correlated assets. This relation occurs because of the nature of these financial instruments: equities are relatively risky but rewarding to invest, while bonds offer lower but fixed income during times of stock market downturn.

Therefore when the economy is booming, corporate profits rise, increasing the demand for stocks. People sell their bonds, reducing bond prices, to finance the purchase of equity. Hence, they share an inverse relationship. It promotes the diversification of a standard portfolio.

Bonds and Commodity Prices:

With the increase in commodity prices, the cost of goods for companies increases. This increase in commodity prices level causes a rise in inflation. Inflation reduces the value of money over the term of the loan, so the interest rates rise to compensate for the loss of value. This increase in interest rate makes bond issue undesirable for companies, which pulls down the bond prices. Thus, we see an inverse relationship between commodity and bond prices.

Commodities and Equities:

Commodity prices can relate to equities both positively and negatively. For commodity-manufacturing companies, rising prices mean higher profit. Due to the production cost remaining same, and revenues rising (due to high commodity prices), the operating profit (revenue minus cost) increases, which in turn drives up equity prices. The impact is inverse for companies that use commodities as raw materials/inputs. Rising prices pull up the cost of production, driving the profits down, which leads to lower equity prices. Therefore, combining investments into commodities and equities doesn’t always mean better diversification.

Gold is a unique commodity which should be explained separately because it serves more as a store of value/alternative investment/equivalent of cash than an actual commodity. The common knowledge is that if an economy does bad and equity markets crash, gold is a way to profit as the yellow metal provides a sense of certainty and physical value.

Limitations of the correlation theory

All these conventional relations may not always hold true. Everything changes during a crisis. When bond prices start falling, stocks will ultimately follow the same direction. With borrowing becoming more expensive and the cost of doing business rising due to inflation, companies’ stock is expected to not do well either, as the earnings per share fall making equity less attractive. Commodity prices also drop. Even the gold can feel the panic among investors and fall for short period of time. In the graph below it is seen that actually correlation between S&P 500 stock index (red line) and gold (blue line) can fluctuate a lot and not necessarily be negative.

Image source: Tradingview.com

What do we see here? During a market downturn, correlation even reverses!

Darius McDermott, managing director at Chelsea Financial Services confirms that “In a crisis, assets can become increasingly correlated. In 2008, for example, many equity, bond and property funds all suffered heavy losses at the same time. Correlations are constantly changing and just because something was uncorrelated in the past, doesn’t mean it will be in the future.”

One concept of the modern portfolio Theory (MPT) proposes that adding a volatile asset to a portfolio can still decrease overall volatility if the returns have differences in correlation. This controversial concept shows that overall portfolio volatility can be decreased by combining asset classes together that, by themselves, have returns with higher volatility. The problem is that investors using such approach should be ready for unpleasant surprise of all their assets suddenly becoming correlated during a crisis.

Considering changes in recent years

Conventional wisdom says that when risk-hungry investors look for higher returns they shift out of bonds, pushing yields higher, into equities, raising stock prices. On the other hand, if investors fear market turmoil, they’ll take shelter in bonds and sell their stocks. But this toggling between the two assets hasn’t showed up this time round in February 2018 during a correction in equity markets. The US 10 year treasury bond price did not react inversely to S&P 500. Therefore, in the USA we have fixed income securities and equities correlating positively for quite some time now and opinions exist that this could hold if economy heats.

“This will hurt conservative investors who bought bonds in order to limit their exposure to wild swings in stocks. In other words, it is becoming very hard to avoid losing money,” said Andrew Lapthorne, a quantitative strategist at Société Générale, in a note dated Feb. 5

In Europe, bonds have become unattractive for several years now for totally different reasons. The central banks have been involved in extensive asset buying schemes and record low interest has meant stocks and bonds now move more frequently in one direction.

Finally, if bonds and correlation diversification are not good options, is there still any proper way to balance an investment portfolio? Yes, there are several options.

How to allocate assets within an investment portfolio

The info chart below confirms that regardless of correlation becoming unpredictable there are still some ways to reduce investment risks. For example, having one investment with a horizon of 10+ years backed by fundamental analysis and two short-term swing trades opened using technical analysis means diversifying across time and investing style.

Image source: https://blog.elearnmarkets.com/portfolio-diversification-simplified/

The bottom line:

Diversified investments show their best in an uneasy market. We, authors, are not saying the next crash is coming soon, but just informing about possibilities to balance investment portfolio. Balancing risk and reward is also beneficial without a global crisis – it can sometimes save from stress or unpredictable human factor. The examples and advice of diversification provided apply best for conservative investors but knowing about asset correlations is really useful for every type of market participant.

Authors: Vincas Vosylius, Andris Barviks

Everything mentioned in this article is not a financial advice and is only for educational purposes. Choose your own strategy according to your interests, risk tolerance and other core values.