Dear Subscribers,
As we continue to navigate volatile financial markets, one concept that deserves your undivided attention is correlation. It’s not just an academic term — correlation is a fundamental building block of any serious portfolio strategy. For those paying €0/month to be part of this community, I want to offer deep insights that you can apply to your portfolio today.
The core of portfolio construction: Correlation and Diversification
You might already know that diversification can reduce risk, but how much risk reduction you achieve depends on the correlation between your investments. Here’s the crux: if the returns of two assets are perfectly correlated (ρ = 1), their combined risk is no different than the risk of holding either one individually. However, when the correlation decreases, the risk of your overall portfolio decreases too, sometimes drastically.
Take a moment to reflect on this: the real power of diversification lies in investing in assets that are not perfectly correlated. Even if both assets are risky on their own, when combined, they can significantly lower overall portfolio volatility. This is one of the reasons why diversified portfolios perform better over time — they leverage the imperfections in the correlations between different asset classes.
Case study: Two-asset portfolio with varying correlations
Let’s dig into a practical example. Imagine you are investing in two assets, Asset A and Asset B. Asset A has a return of 7% and a risk (standard deviation) of 7%. Asset B, on the other hand, has a return of 2% with a risk of 3%. If these assets have a correlation of +1 (they move in perfect unison), the risk of the portfolio is simply a weighted average of the two risks.
But what happens if we lower that correlation to zero or even negative? Here’s the magic: the portfolio risk declines, often substantially, because the asset returns do not move in lockstep. This reduction in risk without a proportional decrease in returns is the essence of diversification.
Impact on your portfolio: How to apply this knowledge
Focus on Correlation, Not Just Returns: When constructing your portfolio, don't just look at the expected returns of individual assets. Always consider how the assets are correlated with one another.
Seek Non-Correlated Assets: For long-term stability, mix asset classes that historically exhibit low or negative correlation, such as equities and bonds. This strategy helps buffer your portfolio against market volatility.
Dynamic Adjustments: Correlations can shift during market crises. It’s vital to review your portfolio regularly and adjust based on changing relationships between asset classes. Even traditionally non-correlated assets, like stocks and bonds, may converge in their movements during extreme market conditions.
Gud one chief !