Mix and Match Different Betas: Correlation - dummies

By David Stevenson

The concept of diversification means that lots of different kinds of markets (in the UK and around the world) and assets (bonds mixed with shares and, say, an alternative asset such as commodities) can give you lots of different betas, and if you’re lucky those different betas don’t move as one; that is, they aren’t correlated as they jump up and down in value.

Thus if equities go down bonds may rise in value along with, say, commodities such as gold. Mixing different betas therefore gives you added benefits and improves returns.

Correlation is a key term that you hear bandied about in the discussion on portfolios and it’s connected to how two different asset classes move in relationship with each other:

  • Positive correlation: If two different asset classes have a positive correlation of 1, they move as one. When one goes up, the other goes up as well. Similarly, when one goes down, so does the other.

  • Uncorrelated: If two different asset classes are uncorrelated (have a correlation of zero), no relationship exists and they move independently of each other.

  • Negative correlation: If the different asset classes have a negative correlation, one moves up as the other moves down.

In an ideal situation, your diversified portfolio has some assets that are positively correlated with each other (perhaps emerging-market stocks and developed-world stocks), some uncorrelated (commodities and bonds) and some negatively correlated (bonds and shares). The key is to mix asset classes with different correlations.

Be careful about putting in your portfolio lots of diversified assets that are very closely correlated with each other. For instance, watch out for lots of apparently diversified assets that all go up or down as one because they have the same sensitivity and therefore increase your risk.

Consider a portfolio made up of Chinese shares, mining company shares quoted on the London stock market and bonds issued by large Canadian banks.

On paper, you seem to have a great deal of diversification within this portfolio, but in reality Chinese shares and UK-based mining shares tend to move in a similar way because in effect you’re buying into the global business cycle and its effect on industrial production in China.

And guess which country has a heavy exposure to mining and whose banks have lent substantial amounts of money to the mining sector? That’s right … Canada and its banks. The bottom line is to think intelligently about diversification to ensure that your portfolio not only includes different asset classes but also includes a balance between positively, negatively and uncorrelated assets.