Holding multiple investments does not ensure better diversification

  • The degree of risk reduction benefit in diversification depends directly upon the correlation of the portfolio’s assets.
  • Adding just one zero-correlated asset to a portfolio reduces risk 29.5%, while adding a thousand 66%-correlated assets reduces risk by only 19%.
  • Well-designed absolute return products can be meaningful additions to traditional allocations, substantially enhancing diversification.

By Todd White, Head of Alternative Investments and Kent Peterson, Ph.D., Senior Portfolio Manager

Most investors are familiar with diversification — reducing one’s risk profile (i.e., annual volatility) without affecting return by adding different asset classes or investments to your portfolio. While this is true, the degree of risk reduction benefit depends directly upon the correlation of the portfolio’s assets. Correlation is the measure of how assets move relative to each other, usually in response to changing economic and market conditions. Highly correlated assets will more often move in unison (e.g., increase or decrease together), while assets with low, zero or negative correlations will behave more independently or even oppositely. Therefore, the less correlated the assets in your portfolio, the lower your risk, and hence the better diversification you achieve.

This is illustrated in the chart below. The left axis shows the volatility of a portfolio as assets (with the same standard deviation) are incrementally added for different levels of correlation. If one had four investments with zero correlation, that investor can cut his or her portfolio’s risk in half. With a portfolio of nine zero-correlated assets, one could reduce his or her risk by two-thirds. But, extending beyond the graph, one finds that even 250 assets with a 33% correlation only brings risk down 42%. So, as correlation rises, even marginally, there isn’t the same diversification benefit. Note how quickly both the 33% and 66% lines flatten out.

Chart: Low correlation factors greatly in risk reduction

Taking this to the extremes, adding just one zero-correlated asset to a portfolio reduces risk 29.5%, while adding a thousand 66% correlated assets reduces risk by only 19%. In short, correlation matters…a lot. One can make one correct and impactful portfolio choice, or a thousand fairly meaningless ones. So, holding multiple investments does not ensure better diversification, but adding a small number of low correlation ones does. The challenge for investors looking to put this into practice is that there simply are not that many traditional assets out there with low correlations to effectively lower the risk in a portfolio. [For a detailed analysis, see our white paper, “Reducing risk: Absolute return and the pursuit of better diversification.”]

This is why well-designed absolute return products — which seek positive expected returns through multiple return streams with consistently low or no correlation to equity or fixed-income markets — can be meaningful additions to traditional allocations, substantially enhancing diversification and strengthening today’s portfolios.

Diversification does not assure a profit or protect against loss.

Absolute return products are not designed to outperform stocks and bonds in strong (upward) markets.

Tagged with: Asset Allocation, Investing

About the Contributor

The views expressed in this material are the views of the author through the date of publication and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable. Past performance does not guarantee future results. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Please see our social media guidelines.

About Us

Backed by more than 100 years of experience, Columbia Management is one of the nation’s largest asset managers. At the heart of our success and, most importantly, that of our investors, are highly talented industry professionals, brought together by a unique way of working. At Columbia Management, reaching our performance goals matters, and how we reach them matters just as much.