Correlation’s essential role in diversification

Columbia Management, Investment Team | December 5, 2013

  • Diversification strategies can help mitigate overall portfolio volatility.
  • An important component of diversification strategies is correlation, or the measure of how one security moves in relation to another.
  • Portfolios with lower correlation among assets will experience less overall volatility, even if the underlying assets are equally volatile individually.

Most investors have heard about the concept of diversification, the typical expression being “Don’t put all your eggs in one basket.” By investing across multiple asset classes, you can help smooth out your portfolio’s overall performance, as poor performing and more volatile investments may be offset by better performing and less volatile ones. While a broad diversification strategy doesn’t guarantee a profit or protect against loss, in this way, it can help mitigate volatility.

But describing diversification as dividing one’s investment dollars among multiple asset classes is only telling half the story. During the financial crisis, for example, domestic and international stocks and corporate bonds all lost value. In contrast, Treasuries didn’t. That’s because the other half of the diversification story is correlation, which is the measure of how one security moves in relation to another.

For example, consider America’s two most popular home improvement chains Home Depot and Lowe’s. Both target the same markets with similar products, so both depend on the same consumers. Therefore, it’s logical that nearly all of the economic factors that impact one will also impact the other. Consequently, we’d say that these stocks are highly correlated, and they’ll perform similarly during any given set of market conditions. So, investing in both does little to further diversify your portfolio.

For greater diversification, it’s important to focus on securities with lower correlations, no correlation or — if possible, because they are less common — negative correlations, meaning when one investment decreases in value, the other usually increases.

The chart below shows the importance of correlation. The purple, teal and blue lines represent three hypothetical portfolios. Each contains 10 different assets with 20% volatility and a 5% return. So the performance of the individual assets is identical. The only difference between them is correlation. Unsurprisingly, the most highly correlated portfolio is the most volatile, and the least correlated portfolio is the least volatile, even though the underlying assets are equally volatile individually.

Lower correlation results in lower portfolio volatility

Chart: the most highly correlated portfolio is the most volatile, and the least correlated portfolio is the least volatile, even though the underlying assets are equally volatile individually.

Source: Columbia Management Investment Advisers, LLC, as of 07/13

Diversification does not assure a profit or protect against loss.

The illustration shown is a hypothetical risk scenario. Securities and characteristics shown are for illustrative purposes only and will differ from those of an actual portfolio in the strategy. There are inherent limitations in any tool and no representation is made that any security will or is likely to achieve a particular rate of return.