Proper diversification using correlation charts
Tom and Marilyn, have 18 different investments in two RRSP portfolios. Most people would think that with 18 investments, you must be diversified but are they diversified properly? When I ran a correlation analysis, 15 of the funds were highly correlated and only 3 of the funds were not correlated. Not surprisingly, they were funds invested in different asset classes. Let’s delve into correlation analysis a little deeper.
What is efficient and effective diversification?
In this diagram we have two portfolios with 5 different investments. The first portfolio has 5 investments that do the exact same thing. All 5 investments go up and the same time and all 5 investments go down at the same time. These funds are highly or positively correlated. The second portfolio is more efficient because it simply has a portfolio of 5 investments that do different things at different times, which helps mitigate risk. These funds are not correlated or negatively correlated. This is called efficient diversification.
I’ve been watching correlation data quite closely and it really does show that effective diversification comes from asset diversification, not investment diversification.
What is investment diversification?
When you hold lots of different investments but not necessarily in different asset classes. Tom and Marilyn had a portfolio that was a good example of investment diversification. Here’s another example I ran into recently:
Jason has a RRSP plan with CI Mutual Funds. He has 7 different investments but they all have high exposure to equities. Let’s take a look at the correlation of these 7 investments
As you can see, the funds are highly correlated. In fact, 4 of the funds (CI Interntational, CI Portfolio Balanced, CI Portfolio Growth and CI Maximum Growth) are all almost perfectly correlated (a number close to 1).
What is asset diversification?
Asset diversification is really another term for asset allocation. Correlation charts show that asset allocation is very important. It is important to diversify between cash, bonds and stocks mainly because these assets do not move in sync with each other. Here’s a chart showing the correlation of different asset classes
Cash, Bonds, Gold, Global markets and Canadian Equities are all correlated differently. You can see this in the numbers or the colors. One interesting point is the global markets are not as negatively correlated as you might think.
Geographic diversification is less important than you might think
If you look at this correlation chart looking at different world markets, you can see that the world markets are moving more and more in sync. Just think about the economic downturns in the world in 2002, 2008 and 2011. Markets around the world went down together. There were not many places stock investors could go to, to get away from the market drops. The only way to diversify properly was to go to different asset classes like cash or bonds.
This data comes from the past 3 years but the data is similar for longer time frames. World markets are more in sync than ever because of globalization and technology. Economies and markets are around the world are more linked than ever.
Sector diversification is important
Unlike global diversification, sector diversification appears to be very important. Here’s a chart of the TSX sectors and the correlation data shows that sector do not move together all the time.
As you can see from this chart there are a two sectors are highly correlated like Real Estate and REITS (Real Estate Investment Trusts). Mining and Health Care are least correlated. In fact, the data suggests that health care is an important sector to own for diversification purposes.
Proper diversification for Jason
If we go back to Jason, remember his portfolio was diversified by investment but not by asset or sector Here’s an example of how Jason could change his portfolio within CI Funds to diversify better
If you take this to another level, Jason may want to look outside of CI for potentially better investments. Jason may want to look at alternatives to mutual funds to access investments with lower fees. For now, I hope these correlation charts help you to understand the science of diversification a little better. Generally it’s more important to diversify by asset and by sector than it is by geography and by investment.
What do you think about diversification and correlation? Do you think these chart make a difference when it comes to designing and managing portfolios?