This was first published in my newsletter, Money Matters. Email firstname.lastname@example.org for a free subscription!
Your investment portfolio is a lot like potato salad! Although this doesn’t seem possible, the similarities are amazing. Potato salad has many ingredients; some taste good by themselves, and some don’t. Your investment portfolio also has many different asset classes in it. Some of them are risky and wouldn’t be wise (or tasty) by themselves, but when combined with other investments, they might help lower your portfolio risk.
Portfolio risk is usually defined as either Beta or Standard Deviation. Standard Deviation is a measure of potential variability of investment returns, and part of the formula is correlation. Correlation is also a mathematical formula that helps you see how related two investments are. In English, do they go up and down at the same time? Highly correlated assets will rise and fall together, while lowly correlated assets won’t.
Adding asset classes that might be risky (when you measure their individual standard deviations) may lower a portfolio’s overall standard deviation if they lower your portfolio’s correlation. This is logical if you think about two items rising and falling differently from each other. The increase of one item helps soften the decline of the other. Like potato salad, the asset classes work better when blended together rather than being consumed individually.
One major danger is that correlation isn’t static, and correlation increases in times of market turmoil. The more things are falling apart, the more likely everything is declining together, especially if the asset classes are in the same major categories (like equities or bonds). At the time you need diversification the worst, you have the highest correlation. Additionally, some investment options are really bad ideas because of other risks they have.
Finally, all good potato salad is a little different from any other you have eaten. Similarly, there are many ways to create a lower portfolio correlation. Talk to your financial planner.