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Fund Correlation Calculator to Build a Truly Diversified Portfolio

In another article we discussed measuring risk using standard deviation. Here we will spend just a little more time to introduce the magic of statistics and how understanding standard deviation and other simple statistical measures can reduce your portfolio risk.

What is correlation? Simply put, it’s a measure of how closely two investments track one another. The unit of measure is the correlation coefficient, which can vary in magnitude from 0 (not correlated at all) to 1 (exactly tracking).

I won’t grind through the math here, but it turns out that if you combine 2 uncorrelated investments (rebalancing often) then the risk (standard deviation) will go down by about 30%. Combining 4 reduces it about 50%. This is powerful stuff. It says that if you can find a handful of high return but high risk investment options, but they have a low correlation to one another, you can have your cake (the high returns) and eat it too (the total portfolio risk is reduced).

It’s this idea that forms the basis of the advice to balance your investments between stocks and bonds, as bonds have a very low correlation to stocks, and with a 75/25 ratio of stocks to bonds you get almost the same return as stocks alone, but with much lower total risk.

The problem is that most equity investments are somewhat correlated to the market, and within a sector they are correlated to one another. That’s why the advice to get at least 8 stocks from unrelated industries in your portfolio, since if they were uncorrelated 8 stocks would reduce the overall risk by almost 2/3. The problem is that there are not that many opportunities to find uncorrelated stocks.

Correlation Calculator

We highlighted an ETF correlation calculator in another article. You can use it to get some idea of the correlation between different asset classes.

See how many you can find that are not correlated to one another (under .2 is great, under 0.4 at a minimum). Remember, if you have 4 funds you are looking at, you need to look at 6 correlation factors, if you have 5 funds you need to look at 10, 6 funds your need to look at 15, and so on. It gets complicated in a hurry.

(Here’s a clue, start with Real Estate and Natural Resources)

Since you won’t find that you can find a large number of funds that have a really low correlation to one another, you may wonder how you calculate the total risk (standard deviation) for funds that have a non zero correlation. It turns out you have to just simulate it, there’s not an easy way to calculate it.

In summary, what we really need to build a high performance low risk portfolio is simply a 4 to 8 funds with high returns, relatively low risk, and low correlation between them. Why doesn’t everyone just do that? As we’ll see next, that’s easier said than done.

Next time: We take a look at using simple correlation to actually reduce risk without sacrificing investment returns.

If you’d like to dig into this concept more, I’d really recommend the book “The Intelligent Asset Allocator”. It’s really an easy read given that he’s covering such a geeky subject. You can buy it at Amazon at

http://fundztrader.com/intelligent

Filed under Asset Allocation

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