If you want your investment portfolio to strike a good balance between risk and return, it’s worth knowing how correlation can impact your investments.
If two different investments are perfectly correlated, their value will rise and fall by the same amount, at the same time. Investing in highly correlated assets can increase your losses, because when one investment falls in value (except for a reason peculiar to it), the others may well do likewise.
Avoiding correlation is crucial for building a well-diversified portfolio. If all your investments move in the same direction, your portfolio is more vulnerable. Owning a variety of investments that move differently can help limit risk and protect your overall portfolio’s value.
Is your portfolio more correlated than you think?
You might be surprised at how closely correlated some of your investments are. This is because many large funds hold similar holdings, which can lead to increased correlation and reduced diversification benefits. Even if you own a globally diversified fund, you might not be as diversified as you think, as allocation to holdings can be closely aligned.
This has become a concern recently, as the performance of the ‘Magnificent Seven’ technology stocks (Apple, Microsoft, Amazon, Alphabet (Google), Meta (Facebook), Nvidia and Tesla, has seen them dominate global portfolios. Should these companies all start to underperform, it could have a substantial impact on overall investment returns.
So, for a truly diversified portfolio, owning a range of investments with low or no correlation, where one investment isn’t virtually certain to move in the same direction as another, is ideal.
The value of investments can go down as well as up and you may not get back the full amount you invested. The past is not a guide to future performance and past performance may not necessarily be repeated.