Use relevant diversification to protect your investment portfolio

Diversification will naturally attract risk-averse creatures in every investor’s heart. Betting all the money on one horse seems to be riskier than spreading the bet on four different horses-and it may be.

But how do you choose these horses? You can use your intuition and choose any four at random. But it’s like playing a game of chance. Professional fund managers do not rely solely on intuition to choose a diversified portfolio.They use statistical techniques to find so-called “irrelevant assets.” Irrelevant assets can help you diversify your investment portfolio and manage risk-this is good news for investors who are worried about the uncertainty of rolling the dice.

But it’s not perfect: diversifying your portfolio by picking unrelated assets may not always work. In this article, we will show you what relevance is and explain how unrelated assets work and when they are not.

Key points

  • The concept of investment diversification refers to having multiple securities of multiple asset classes to withstand risks.
  • Historically, stocks and bonds have been used as examples of two unrelated asset classes.
  • Diversification is most effective when assets are uncorrelated or negatively correlated with each other, so as some parts of the portfolio decline, other parts rise.

Numbers game

Correlation is a number between +1.0 and -1.0 to measure the degree of correlation between two variables. For a diversified investment portfolio, correlation indicates the degree of correlation between the price changes of different assets included in the investment portfolio. A correlation of +1.0 means that prices move synchronously; a correlation of -1.0 means that prices move in the opposite direction. A correlation of 0 means that the price change of the asset is irrelevant; in other words, the price change of one asset has no effect on the price change of another asset.

In practice, it is difficult to find an asset pair with a completely positive correlation of +1.0, a completely negative correlation of -1.0, or even a completely neutral correlation of 0. The correlation between different asset pairs can be any one of many possibilities between +1.0 and -1.0 (for example, +0.62 or -0.30). Therefore, each number tells you how far or how close you are to the perfect 0 where the two variables are uncorrelated. Therefore, 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 it can be said that the correlation between asset A and asset B is higher than the correlation with asset C.

If two pairs of assets provide the same return under the same risk, choose less Correlation reduces the overall risk of the investment portfolio.

Not all assets are created equal

Some plants grow on snow-capped mountains, some grow in desolate deserts, and some grow in rainforests. Just as different weather has different effects on different types of plants, different macroeconomic factors have different effects on different assets.

Similarly, changes in the macroeconomic environment have different effects on different assets. For example, the prices of financial assets (such as stocks and bonds) and physical assets (such as gold) may go in opposite directions due to inflation. High inflation may cause the price of gold to rise, and vice versa may cause the price of financial assets to fall.

Use correlation matrix

Statisticians use price data to understand how the prices of two assets have changed relative to each other in the past. Each pair of assets is assigned a number, which represents the degree of relevance of its price changes. This number can be used to construct a so-called “correlation matrix” for different assets. The correlation matrix makes the task of selecting different assets easier by showing the correlation between them in tabular form. Once you have the matrix, you can use it to select various assets that have different correlations with each other.

When choosing assets for your portfolio, you must choose from a wide range of permutations. No matter how you play in a portfolio of multiple assets, some assets will be positively correlated, some will be negatively correlated, and the correlations of other assets may be scattered around zero.

Start with a wide range of categories (such as stocks, bonds, government securities, real estate, etc.), and then narrow down to sub-categories (consumer products, medicine, energy, technology, etc.). Finally, select the specific assets you want to own. The purpose of choosing irrelevant assets is to diversify your risks. Keeping unrelated assets ensures that your entire portfolio will not be killed by a stray bullet.

Relate unrelated assets

A single stray bullet may not be enough to kill an unrelated portfolio of assets, but when the entire financial market faces an attack by financial weapons of mass destruction, then even completely unrelated assets may die together. A major financial downfall caused by the evil alliance of financial innovation and leverage may cause all kinds of assets to suffer the same blow. This is what happened during the near collapse of the hedge fund Long-Term Capital Management in 1998. This is also what happened during the 2007-08 subprime mortgage crisis.

The lessons learned from these things now seem to be well learned: leverage—the amount of money borrowed for investment—is two-way. By using leverage, you can assume a risk exposure that is many times greater than your capital. When you win consecutively, the strategy of using borrowed money to get a high risk is very effective. Even after repaying the arrears, you can get a greater profit. But the problem with leverage is that it also increases the potential loss of investment errors. You must repay the money you owe from other sources.

When the price of an asset plummets, the level of leverage may force the trader to liquidate his good assets. When a trader sells his good assets to make up for losses, he has little time to distinguish between related assets and unrelated assets. He sells whatever he has. In the cry of “sell, sell, sell,” the price of good assets may also go downhill. When everyone holds a similarly diversified portfolio, the situation becomes complicated. A decline in one diversified portfolio is likely to cause a decline in another diversified portfolio. Therefore, a major financial crisis will put all assets into trouble.

Bottom line

In difficult economic times, irrelevant assets seem to have disappeared, but diversification still plays a role. Diversification may not provide complete disaster insurance, but it still retains its charm as a defense against random events in the market. And, although it is possible to obtain high returns by acting cautiously, the risks involved explain why most first-time investors tend to do so.

Remember: only complete elimination can kill all assets together. In all other cases, although some assets die out faster than others, some assets do survive. If all assets went to waste together, the financial markets we see today would have long since died.

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