- 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.
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.