The importance of diversification and correlation in investments

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Investing

Gareth Trainor

19th December 2017 at 11:00am

The importance of diversification and correlation in investments

One of the most important questions any investor can ask themselves is: “Am I diversified…enough?”.

I’m always keen to remind investors of the importance of this pillar of investment know-how and the science bit that makes it most useful – correlation. It’s how you can best balance return and risk.

Let’s look at the what, why and how, and finish with some useful examples to really get you thinking about diversification and investments.

What is correlation?

Different types of investments (or asset classes) are affected in different ways by factors such as economics, interest rates, politics, conflicts, even weather events. What’s positive for one can be negative for another, and when one rises another may fall. This interlinked movement between asset classes is known as correlation.

Correlation is the science bit of diversification – it explains how to make your investments efficient over the long term.

Think of a raincoat company and an ice cream company. You invest all your money in the raincoat company and make good returns during the rainy months but poor returns in the sunny months. The reverse would happen if you put all your money in the ice cream company. The returns of both companies are likely to move up and down at different times – meaning they’re negatively correlated. But investing in both – in other words diversifying – would reduce your risk of poor returns at certain times.

Why it can be important to diversify

It’s easy to be lured by the attractions of a single asset class when it’s doing well. Or to be frightened off when it isn’t.

But we shouldn’t be making decisions based solely on previous performance. For instance, if you invested your money in 2014 in UK Commercial Property you’d have been rewarded with a 19.5% return. But in 2016 you would have seen only a slight increase of 2.6%. Similarly Emerging Market equities during 2015 saw a loss of 10.3% but those same assets generated a return of 35.4% in 2016.

We can’t predict all the factors affecting the performance of different asset classes. News that lifts equities can depress bonds and in most years the difference between the best and worst performing asset classes is big – really big. But don’t worry about assets performing well at different times. That’s correlation and you can benefit from it – if you diversify enough.

Here’s how you diversify

Professional investors look at the interactions of all the asset classes in different combinations and circumstances. They diversify to balance out the fluctuations in their performance. This is key. We don’t diversify to maximise performance, we diversify to achieve the best balance between return and risk.

You’ll get the benefits of diversification when you increase the amount of investments you have which aren’t perfectly correlated. But to get the most out of it, you have to make sure they’re the right investments in just the right amounts.

Correlation is the science bit of diversification – it explains how to make your investments efficient over the long term. Given the interconnected nature of all of the potential investments in the world, it can be difficult to get right. The best approach is not to think about investments’ individual characteristics, but the impact they have on your overall portfolio.

If you held five investments, you would get the average return of those investments. However, assuming they behave differently (they’re not perfectly correlated), you would get less than the average risk. That’s what diversification gifts you; with the right investments blended in the right proportions, for every unit of risk you take you’ll get a better return.

Many investment companies have dedicated teams supporting their diversification strategies.

If you don’t want to tackle it yourself, there are plenty of ready-made, diversified investment options that aim to deliver the highest possible return for a given level of risk – these do the hard work for you.

But if you’re a knowledgeable investor you might want to do it yourself. To help get you thinking about the correlation of asset classes, have a look at the following matrix showing the relationship between a variety of equities, bonds, property, and money market investments (cash) over three years to the end of 2017.

Correlation Matrix for equity assets.

Examples of correlation in numbers

Asset class correlation measures the strength of the relationship of two different asset classes. It’s represented by a number between +1.00 and -1.00

  • Negative correlation

If two asset classes are negatively correlated, their performance will generally be in the opposite direction. For example, a correlation of -1 would give perfect negative correlation.

From the matrix, a correlation of -0.38 means that corporate bonds and emerging market equities are moderately negatively correlated.

  • Positive correlation

If two asset classes are positively correlated, their performance will generally be in the same direction. The higher the positive correlation, the stronger the relationship between the two asset classes. A correlation of 1 would give perfect positive correlation.

From the matrix, a correlation of 0.94 means that emerging market equities and Asia Pacific ex Japan equities are highly positively correlated.

  • Uncorrelated asset classes

Assets with a zero correlation figure have no relationship at all. The closer the number to zero, the lower the relationship. From the matrix, the two asset classes with the lowest correlation are Japanese equities and UK government bonds with a correlation of -0.01.

These numbers don’t include charges that you’d have to pay if you invested in these asset classes through a fund.

Review, review, review

Whatever you decide to do, whether that’s doing it yourself or opting for a ready-made option it’s important to keep an eye on your investments. Check in regularly and make sure they’re still on track to meet your goals.

But don’t just look at performance. Yes, it can be useful, especially if you compare this against the investments’ aims and how other similar things have done. But it’s important to look at your investments as a whole too. For example, if you look at any ISAs, pensions or shares you have, do you know how much you have in each asset type or region? A quick check could highlight any obvious issues.

 

SOURCE OF INFORMATION

Fund Source
UK equities FTSE® All Share Index
Europe ex UK equities FTSE® World Europe EX UK Index
North American equities FTSE® World North America Index
Japanese equities FTSE® Japan Index
Asia Pacific ex Japan equities FTSE® World Asia Pacific EX Japan Index
Emerging market equities FTSE® Emerging Index
UK government bonds FTSE® British Government All Stocks Index
Corporate bonds iBoxx Stg CORP. ALL MATS
High yield bonds The BofA ML Global High Yield Index
UK property IPD UK All Property Index
Cash LIBOR GBP 1m

Always remember that there are no guarantees – the value of your investment can go down as well as up, and may be worth less than you paid in. Past performance is not a guide to the future. Performance calculated using FinXL. In pounds sterling, gross income reinvested.

The information in this blog or any response to comments should not be regarded as financial advice, and is based on our understanding in December 2017.

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