30th March 2016
James Yardley, senior research analyst, Chelsea Financial Services, considers a thorny issue for many investors.
So you’ve bought a bunch of different funds and built a portfolio. You’ve got some equities, some bonds, some commercial property, and you’ve got exposure to different parts of the world. You’re diversified, right? Wrong.
Diversification is not as simple as buying different asset classes and sticking them together. What matters is how ‘correlated’ your funds are to one another. What does that mean? Simple, do your funds rise and fall together, or do they move independently?
The less correlated an asset is, the more value it brings to your portfolio. So a perfectly positively correlated asset—an asset that rises and fall exactly in line with another asset—gives no diversification benefit at all.
When you build your portfolio, you want to add in assets that are independent or likely to do well when our other assets fall.
Unfortunately, finding assets that are truly uncorrelated is harder in practice than it is in theory. Correlations are constantly changing. Just because something was uncorrelated in the past, doesn’t mean it will be in the future.
In a crisis, assets become increasingly correlated. In 2008, many equity, bond and property funds all suffered heavy losses at the same time, as you can see in the chart below.
Meanwhile, multi-asset funds were supposed to be well diversified and provide investors with protection when equity markets fell. As you can see below, even those with limited stock market
exposure suffered large losses very quickly. These funds may have sounded good in theory, but in practice investors had little protection.
So building a portfolio that can truly protect you takes a great deal of skill. To see what I mean in a bit more detail, look at the two correlation matrix tables below.
At first sight these tables look a bit intimidating, but they needn’t be. All they show is the historical correlations between different asset classes. Correlation is measured using numbers between 1 to -1.
The tables are colour coded as follows:
The first table below shows the correlation between asset classes over the past 15 years. You might think this is a good barometer for choosing the most diversified assets for your portfolio; however, keep in mind this is historical data and correlations are constantly changing.
FE Analytics, IA sectors, correlation data, 03-03-2001–03/03/2016, accessed 04/03/2016 . Correlations between assets are between -1 (perfectly negatively correlated) and 1 (perfectly positively correlated). A correlation of 0 means the two assets have no correlation and returns are totally independent of one another.
Of more interest is this second table. It shows correlations during the financial crisis between October 2007 and October 2008.
Notice how the table has changed dramatically and a lot more of the table is now dark blue. This is because many assets become more correlated in a crisis. This can mean you are not as well diversified or protected as you thought.
As you can see, the correlations for many asset classes massively increased over the crisis to the point where some were almost at 1, offering no diversification benefit at all.