Diversity and correlation
Head of Investments Europe Kenneth Volpert discusses how to construct an investment portfolio that is properly diversified.
In creating a portfolio, we start by considering the reason for investing. What goals are we trying to achieve? What is our time frame? How much risk are we willing to take?
The answer to these and other questions will help define how we go about building the portfolio.
My name is Ken Volpert. I am Vanguard’s head of investments in Europe. I’d like to discuss building a diversified portfolio.
Most portfolios are built from core asset classes such as equities, bonds and cash. Each of these asset classes has different characteristics. They vary in terms of their volatility and their long-term returns.
At any point, the equity and bond markets may be moving in different directions, and for different reasons. Meanwhile, within the equity and bond markets, individual shares and bonds may also behave independently, each driven by its own individual news flow.
In technical terms, we say that these markets, and the securities within them, are not perfectly correlated. Let me explain in a bit more detail.
Correlation is a measure of the extent to which one investment moves in step with another.
Two investments that move exactly in step with each other can be said to have a correlation of positive-one.
Investments that always move in opposite directions can be said to have a correlation of negative-one.
Where two investments behave in a way that the direction of one has no relationship to the other, they can be said to have a correlation near zero.
In the investment markets, risks which can be diversified away … do not earn a return premium. When we build an investment portfolio, we want the risk that is taken to be rewarded with additional return. The way to do this is to get the right balance between risk and reward, to ensure the portfolio is properly diversified.
We create a diversified portfolio by combining assets that have a low correlation.
In reality, we can reasonably expect asset classes that have correlations between -.5 and +.9, with positive risk premiums for the market risk taken.
Examples of risk premiums are term structure and credit risk in bond markets. Equities are subject to a number of risks which can be described as the equity risk premium.
In this case, a well-diversified portfolio would look something like this. Here we have asset A –
We then add asset B –
The two assets combined in a portfolio will help to minimise risk, and in particular remove risk that is not being rewarded… So the actual return profile of the portfolio will look something like this…
The combined portfolio is clearly less volatile.
An important final point is that diversification is not about enhancing returns. That is driven by the type of assets you select for your portfolio. Diversification is about managing risk – and hopefully minimising portfolio level volatility. The end-point could possibly be the same, but many investors will not have the staying power to endure large losses along the way, especially if there is a chance of those losses coming at a moment when they need to cash in their investment.
Diversification will help to smooth the journey and increase the probability that the portfolio is in the right place when it comes time to spend down the accumulated wealth.
Understanding the concept of correlation and the benefits of diversification gives us a great start towards successful portfolio construction. It allows us to combine assets in different proportions to target varying levels of return, with appropriate levels of expected risk. And that should mean we can build portfolios that meet a wide range of goals.
Thank you for watching.
Investment risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
Other important information:
This video was produced by Vanguard Asset Management, Ltd. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
If this is to be used on third party websites for an audience of professional investors as the submission suggests I would also include the for professional investors disclaimer at the top.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
© 2018 Vanguard Asset Management, Limited. All rights reserved.