When we say diversification in a portfolio- the first thought comes to our mind is “a blend of different asset classes” or a pie diagram representation with colorful pieces. That’s the perfect picture we have in our mind for word – Diversification !  and it’s not wrong at all. But diversification is not just about dividing your investment’s in different asset classes to minimize risks. Diversification is more concentrated on co-relation of assets. It’s not about having a bunch of assets in a portfolio but about holding the asset with low correlation to each other. So, What the heck is this – Correlation, let’s find out.

Correlation:

As per Definition – “A statistical measure of how two securities move in relation to each other”.

In simple words, it is a measure of how return on investment move in relation to one another. It is expressed in number as -1 or +1. When two assets shows negative (-1) correlation it means both assets moves in an opposite directions. Positive(+1) correlation means both the assets moves in same direction. Zero correlation indicates no relationship between the two assets.

Let’s try to understand this concept with some examples.

Positive correlation

Two or more assets have positive correlation when they move, up/down in same direction. e.g. same sector stocks have high correlation.

Negative Correlation

Two or more assets have a negative correlation when they move, up/down in an opposite direction. e.g. Stocks and Bonds.

Diversification & Correlation:

Correlation is the heart of Portfolio Diversification/Asset Allocation. The main objective of diversification in a portfolio is to minimize risk; and correlation of asset classes helps minimize that. What this means is – if asset holding in a portfolio have low correlation to one another it will automatically decreases the risk. By combining assets which have negative correlation, you can make a portfolio efficient enough to earn more returns with low risks.

Portfolio Diversification:

Diversify your portfolio not just by holding different asset classes but also by each asset class.

• Diversify your Stocks portfolio through different sectors; also with small, mid and large cap stocks.
• Diversify your Bonds or Interest instruments on the basis of maturity dates, interest rates and tax treatments.
• Gold is an investment which has almost negative correlation with stocks.
• Cash carries a zero correlation with almost each asset class. Therefore holding it can save you in diminishing markets.

So, diversify your portfolio and each asset class with low correlated assets over the long term.

Choose asset classes according to your goals, age, savings and available time. It will certainly help you achieve your goals.

See you later 🙂

References:

Fidelity