One of the first rules you’ll learn as an investor is to diversify.
The concept is pretty simple…
It means you should hold different types of assets in your portfolio to spread out your risk… such as a mix of stocks, bonds, and precious metals.
But proper diversification isn’t as straightforward as it might sound…
This article will teach you one diversification strategy that isn’t common knowledge—a strategy used by elite investors to ensure a much stronger portfolio…
But first, let’s look at why diversification is so important.
How diversification protects your portfolio
Seasoned investors know it’s not wise to make a large single-stock bet.
Putting all your eggs in one basket isn’t a good strategy in life or finance.
While the potential upside might be tantalizing… the potential downside would be even more devastating.
All else equal, several smaller bets are safer than a single large one. That way, your portfolio isn’t subject to the whims of one single stock.
But simply adding more stocks from the same one or two economic sectors can be almost as harmful.
That might sound obvious, but all too often, investors find themselves drawn to a few particular sectors—to the detriment of their portfolio. Having a portfolio that’s overweight in one or two specific sectors creates much the same risk as investing in a single stock.
That’s because of a market feature called correlation.
And understanding correlation is the key to a properly diversified portfolio.
How assessing correlation makes a portfolio stronger, safer… better
In 1990, Baruch professor Harry Markowitz was awarded the Nobel Memorial Prize in Economic Sciences for proving that holding uncorrelated assets—assets that move in opposition to one another—reduces portfolio risk.
Markowitz’s discovery is now a cornerstone of any well-diversified portfolio.
Let’s unpack this…
If you’ve been investing for a while, you know that some stocks always follow each other… some movements are completely unrelated… and others move in polar opposite directions.
This all can be measured by the correlation coefficient.
A coefficient can range from -1 (perfectly negative correlation) to +1 (perfect correlation). (A measure of 0 means the assets have no correlation.)
Put simply, the higher the coefficient, the more closely assets follow one another, and vice versa.
For diversification purposes, the lower the correlation coefficient, the better.
When one security in your portfolio moves lower, uncorrelated securities are likely to remain steady… while securities with negative correlations could even move higher.
This becomes especially valuable in a downturn, as one negatively correlated asset could offset a decline in another.
Let’s take a look at two strongly correlated assets: Home Depot (HD) and Lowe’s (LOW).
Because these stocks are largely affected in the same way by specific economic trends (such as in the housing market, DIY retail, consumer spending, etc.), HD and LOW tend to move in similar patterns.
So, if the sector plunges, both stocks will likely feel the pain.
Now, let’s look at an example of negatively correlated assets: stocks and bonds.
When the market drops, bonds typically rally—and vice versa.
So, by holding both in your portfolio, this negative correlation pattern would help keep returns stable over time. (This is why financial planners suggest holding both stocks and bonds.)
And finally, let’s look at an example of uncorrelated assets: stocks and gold.
Typically, the movements in one asset class have little to no bearing on the movements of the other. (That’s why gold is often considered a safe haven against market volatility.)
While the concept of portfolio correlations isn’t hard to understand, applying it might become complicated…
Stocks and bonds, for example, can start moving in the same direction… Some stocks in a sector might part ways from the rest… Or a stock might hitch a correlation ride with a fully unrelated market sector. In other words, patterns change, so make sure to do a regular correlation check of your holdings.
If you do, understanding correlation can be a great way to diversify… reduce your risk… and build a much stronger portfolio.
And for more investing strategies, as well as stock tips and deep-dive market insights, tune into Wall Street Unplugged Premium each week.
