Diversification naturally appeals to the risk-averse creature inside every investor. Betting all your money on just one horse seems riskier than spreading out your bets on four different horses - and it can be.

But, how do you choose those horses? You can use your intuition and randomly pick any four. But that would be like playing a game of chance. Professional fund managers don't rely merely on their intuition for picking a well-diversified portfolio. They use statistical techniques for finding what are called "uncorrelated assets." Uncorrelated assets can help you diversify your own portfolio and manage risks - good news for investors who are wary of the uncertainty in rolling dice.

But it's not perfect, either: diversifying your portfolio by picking up uncorrelated assets may not always work. In this article, we show you what correlation is and explain how uncorrelated assets work - and when they don't.

A Game of Numbers
Correlation statistically measures the degree of relationship between two variables in terms of a number that lies between +1 and -1. When it comes to diversified portfolios, correlation represents the degree of relationship between the price movements of different assets included in the portfolio. A correlation of +1 means that prices move in tandem; a correlation of -1 means that prices move in opposite directions. A correlation of 0 means that the price movements of assets are totally uncorrelated; in other words, the price movement of one asset has no effect on the price movement of the other asset.

In actual practice, it's difficult to find a pair of assets that have a perfect positive correlation of +1, a perfect negative correlation of -1 or even a perfect neutral correlation of 0. In fact, correlation between different pairs of assets could be any one of the numerous possibilities lying between +1 and -1 (for example, +0.62 or -0.30). Each number thus tells you how far or how close you are from that perfect 0 where two variables are totally uncorrelated. So, if the correlation between Asset A and Asset B is 0.35 and the correlation between Asset A and Asset C is 0.25, then you can say that Asset A is more correlated with Asset B than it is with Asset C.

If two pairs of assets offer the same return at the same risk, choosing the pair that is less correlated decreases the overall risk of the portfolio.

All Assets Are Not Created Equal
Just as different weather affects different kinds of plants differently, different macroeconomic factors affect different assets differently. Some plants thrive on snow-capped mountains, some grow in wild deserts and some grow in rain forests. Dramatic changes in global climate adversely affect some plants, whereas others will flourish. (For more on macroeconomics, see Macroeconomic Analysis.)

Likewise, changes in the macroeconomic environment have different effects on different assets. For instance, prices of financial assets like stocks and bonds, and non-financial assets like gold, may move in opposite directions due to inflation. High inflation may lead to a rise in gold prices, whereas it may lead to a fall in prices of financial assets.

Making the Right Move: Using a Correlation Matrix
Statisticians use price data to find out how the prices of two assets have moved in the past in relation to each other. Each pair of assets is assigned a number that represents the degree of correlation in their price movements. This number can be used for constructing what is called a "correlation matrix" for different assets. A correlation matrix makes the task of choosing different assets easier by presenting their correlation with each other in a tabular form. Once you have the matrix, you can use it for choosing a wide variety of assets having different correlations with each other.

While choosing assets for your portfolio, you have to choose from a wide range of permutations and combinations. No matter how you play your hand in a portfolio of many assets, some of the assets would be positively correlated, some would be negatively correlated, and the correlation of the rest could be scattered around zero.

Start with broad categories (like stocks, bonds, government securities, real estate, etc.) and then narrow down to subcategories (consumer goods, pharmaceuticals, energy, technology and so on). Finally, choose the specific asset that you want to own. The aim of choosing uncorrelated assets is to diversify your risks. Keeping uncorrelated assets ensures that your entire investment is not killed by just one stray bullet.

Making Uncorrelated Assets Correlated
One stray bullet may not be enough to kill a portfolio of uncorrelated assets, but when the entire financial market is facing assault by weapons of financial mass destruction, then even totally uncorrelated assets may perish together. Big financial downfalls caused by an unholy alliance of financial innovations and leverage may bring assets of all kinds under the same hammer. This is what happened during the collapse of Long-Term Capital Management. It's also what happened during the financial market crisis in 2007-08.

The lesson now seems to be well taken: leverage - the amount of borrowed money used to make any investment - cuts both ways. By using leverage, you can take exposure that is many times more than your own capital. The strategy of taking high exposure by using borrowed money works perfectly well when you are on a winning streak. You take home greater profit even after paying back the money that you owe. But the problem with leverage is that it also enhances the potential of loss from an investment gone wrong. You have to pay back the money that you owe from some other source.

When the price of one asset is collapsing, the level of leverage may force a trader to liquidate even his good assets. When a trader is selling his good assets to cover his losses, he hardly has time to distinguish between correlated and uncorrelated assets. He sells whatever is there in his hands. During the cry of "sell, sell, sell," even the price of good assets may go downhill. The situation becomes really complicated when everybody is holding a similarly diversified portfolio. The fall of one diversified portfolio could very well lead to the fall of another diversified portfolio. So, big financial downfalls can put all assets in the same boat.

During hard economic times, uncorrelated assets may seem to have vanished, but diversification still serves its purpose. Diversification may not provide complete insurance against disaster, but it still retains its charm as a protection against random events in the market. Remember: Nothing short of a complete wipeout would kill all kinds of assets together. In all other scenarios, while some assets perish faster than others, some do manage to survive. If all assets went down the drain together, the financial market that we see today would have been dead long ago.

Related Articles
  1. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  2. Investing Basics

    5 Things To Know About Asset Allocation

    Overwhelmed by investment options? Learn how to create an asset allocation strategy that works for you.
  3. Investing Basics

    Introduction To Investment Diversification

    Reducing risk and increasing returns in your portfolio is all about finding the right balance.
  4. Active Trading

    When Geographic Diversification Fails

    Geographic diversification is becoming an ineffective investing strategy, but there are others that pay off in the long term.
  5. Insurance

    The Dangers Of Over-Diversifying Your Portfolio

    If you diversify too much, you might not lose much, but you won't gain much either.
  6. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  7. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  8. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  9. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  10. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  1. What are some of the arguments in favor of debt securitization?

    Debt securitization, or instrument securitization as a whole, received a bad reputation following the financial crisis of ... Read Full Answer >>
  2. How do I find positive correlation in the stock market?

    Positive correlation refers to a statistical relationship in which two variables generally move in the same direction together. ... Read Full Answer >>
  3. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  4. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  5. Can hedge fund returns be replicated?

    You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
  6. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center