Financial Planning and Money Management
Financial Planning and Money Management
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Blog By:
Kon Litovsky
Kon Litovsky

Managing Investment Risk Part 2: Correlation and Diversification

12/26/2013 7:23:30 AM   |   Comments: 0   |   Views: 5791

Hedge funds, managed futures, commodities, private placements, oil and gas exploration, non-listed REITs…what do all of these have in common? The sellers usually claim that their product will provide the necessary diversification for your portfolio. They claim they have numbers to prove it, too. Here are some of the common features of the so-called diversifiers:

  • Usually illiquid (that is, hard to redeem).
  • Very high expenses and fees that may be hidden in the fine print.
  • Extremely high risk of losing money due to circumstances of which most investors are unaware and can not control.
  • Very complex, hard to understand and difficult to research because very little information is available.
  • Too good to be true returns, which simply hide the fact that these investments are risky.

But what if you get what you paid for, despite all of the drawbacks? Do these investments really work to diversify your portfolio? Investors are conditioned to believe that diversification is somehow supposed to protect your portfolio from big crashes. However, in practice, we can see that very few people were able to avoid the carnage of 2008 when the S&P 500 index lost as much as 50% at one point.  There is a belief among professionals that if somehow we are able to assemble a number of uncorrelated or negatively correlated assets, that is, assets which do not move together, then we would be able to diversify away the risk of loss when the market crashes.  This sounds great in theory, but in practice we have nothing of the sort.  Everything is hopelessly correlated in the most complex fashion, and there is nothing we can do about it.  The following plots illustrate the correlation of gold, oil, treasuries and international stocks to S&P500 index (domestic large capitalization stocks) in time. Negative correlation means that the asset classes move in the opposite directions, zero correlation means that the asset classes are not correlated in any way, and positive correlation means that the asset classes move together.

Gold and commodities are always being touted as the best portfolio diversifiers.  However, these plots show how different asset classes (commodities, international stocks, domestic government bonds) can all of a sudden move in sync with the S&P500 index (higher correlation). For perfect diversification, we want negative correlation – its great when bonds rise when stocks fall.  Zero correlation, in theory, should works too – though not as well as negative correlation. But what we see from the above charts is that this is not to be taken for granted, and there is no rule of thumb that is always true.  We can also see that correlation can not be reduced to a single number, even for a single week.  Week by week, the numbers can jump erratically, and if a daily chart could be observed, we would see the same type of erratic behavior. Because of the apparent random nature of the correlation plots, future correlation can not be predicted, as it constantly changes from negative to positive, making it very difficult to make sure that different investments are truly uncorrelated or negatively correlated, because past history does not say very much about how correlation we can expect in the future.  Thus, we can not take the magnitude and the sign of correlation for granted.  When a crash comes, and we know crashes come quite often nowadays, correlation between different asset classes can spike like it did in 2008, leading to big losses across the board.

The one and only rule one needs to remember is this: the less risk – the better. If you don’t take any risk (cash, CDs) – you will not lose any money.  If you take a lot of risks, by investing in stocks for example – you can lose as much as 100% of your investment. Even risks which are deemed to be low probability have to be considered when making investment choices, especially when considering investments that are not listed on major exchanges, as well as those that rely on extremely speculative strategies. Investors often misprice risk, and end up paying for it.  The above correlation charts provide one reason why it is impossible to limit your risk,and why it is so difficult to price risk correctly. By piling on risky investments on top of each other we don’t get lower risk – we get the same high risk associated with each of the investments.  This may not be true all the time, but when it matters most, just like it happened during the crash of 2008, everything can fall hard all at once.  The only way to decrease risk is to put a good portion of your money in safe investments, such as cash, CDs, and to some extent short/intermediate term government and municipal bonds. At some point, you will get diminishing returns, as your CD portfolio may not meet your future needs, so some stocks and bonds exposure may be needed, but not as much as many so-called experts suggest.

The best ‘hedge’ in this recession turned out to be cash and treasuries, as well as bond funds which track US Aggregate Bond Index – the most boring investments. Is it always the case? When inflation is high, cash is not much of a hedge, and treasuries may not always be the best  diversifier, but the most important rule of portfolio management has to always be followed – don’t risk more than you can afford to lose.  When inflation hits double digits and treasuries stop being a relatively safe investment we will have other problems to worry about, but in the meanwhile, there is no reason to consider fancy investments when trying to diversify.

So whenever anybody tries to sell you an investment just remember this: a simple, transparent and liquid portfolio can go a long way.  The opposite of the types of opaque investments described above are:

  • Very liquid, sold on major exchanges, very low spread (ETFs), offered by major Mutual Fund company (Fidelity, Vanguard).
  • Very low expenses, offered at low or zero commissions by the Fund company.
  • Transparent risk due to the overall stock market risk, and nothing else.
  • Very simple, easy to understand prospectus, clear investment strategy.
  • Returns due to the market, not manager mistakes/luck.

Finding that ‘one’ gem or one investment product to make you rich is like betting on horses. The problem is, its no good to bet on an investment for 20 years just to find out after 20 year that this investment underperformed relative to a simple passive index, which is almost always the case.  It is even worse when an investment turns out to be a Ponzi scheme, or goes bust because of the risk the manager took to achieve stellar returns. Following these guidelines will help avoid many mistakes made by investors who are sold investments they never heard of by somebody who managed to gain their trust with a clever sales pitch.

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