In our last post, we discussed the idea of Portfolio Optimization. The main idea is to earn return and mitigate risk. This post will cover a technique to doing so. Risk mitigation in general is achieved through Diversification.
Diversification can be achieved in two ways:
1) Invest in a wide variety of stocks
2) Invest in an index fund (that invests in a variety of stocks for you)
This is common knowledge, however, what most people do not consider when selecting stocks or indices, is Correlation. Correlation is a measure of similarity between the returns of two investments. You can invest in 10 index funds, but if they all correlate with each other, then they will all go down at the same time, and all go up at the same time. This behavior is just as risky as owning 1 index fund and doesn't mitigate any risk. When selecting investments, you want investments that no not correlate but still earn good returns. It is often difficult to find investments that do not correlate at all, so investors will often combine negative correlation stocks in a portfolio to achieve a net diversified effect. To understand correlation, lets look at a specific example of Gold vs the SnP500 Index.
The correlation between the SnP500 Index returns and Gold returns is -13%, meaning for every 1% the SnP goes up, gold goes down by 13% and visa versa. Negatively correlated investments combined together will reduce risk, however, they will also unfortunately stifle returns, because while one investment is performing well, the other is performing poorly. Ideally, each investment in the portfolio earns returns and has a zero correlation with the rest of the portfolio. This way, it is possible for all investments to go up, but also, for one to go down while the others go up. In the long run, this will yield the highest risk adjusted returns. Again, this is very difficult to achieve, however, you can use our free correlation calculator to your advantage.
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