April 17, 2023

Investing in Diversified Asset Classes - Correlation and Diversification Benefits

Correlation is a statistical measure of how closely prices of different assets move together or in opposite directions. A correlation of +1 means that prices of assets move up and down together (though possibly by different amounts). The minimum correlation is -1.0, or -100%, meaning that prices move up and down in the opposite direction.

Investing in Diversified Asset Classes

Correlation can help you diversify your portfolio by spreading your risk across different assets. This is the core of modern portfolio theory.

Typically, the best diversification benefits are achieved by investing in investment products that have low or negative correlations and high returns. This is because low or negative correlations reduce portfolio risk, which in turn improves returns.

As you can see from the chart above, when the correlation between two assets is -1, the efficient frontier bends to the left and there will be a point where there is no diversification benefit. This point is represented as O in the chart.

In the opposite direction, when the correlation between the two assets is 1.0, no diversification benefits are possible because any change in one asset will be reflected in the other asset. This is why it is important to choose the right asset allocation and investments for your individual situation.

International diversification should continue to provide diversification benefits, but correlations in overseas markets may be rising. This should not discourage you from investing internationally, however.


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