Diversification, correlation and over-diversification

Let me get straight to the point. While no-one can credibly contest the merits of diversification in an investment portfolio. It is all too often that investors end up with a long list of non-performing assets simply in the name of diversification. It is imperative to avoid the proverbial eggs and basket idiom, but too many rotten eggs, however diversified, is not at all desirable.

So, can there be such thing as over-diversification? Is negative correlation between different investments a good thing?

Let us start with some simple definitions;

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives. There are many studies demonstrating why diversification works, but to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility.

Correlation, in the finance and investments, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management to estimate measures of risk in the portfolio.

Negative correlation between two assets implies that if the asset price of an asset is moving upwards (positive), the asset price movement of the other is negative.

So let us try to dispel some myths;

1. The more assets I have in a portfolio the better diversified

Modern portfolio theory suggests that anything above your 20th holdings in an asset class does not add much to diversification. Many investors have the misguided view that risk is proportionately reduced with each additional investment in a portfolio, when in fact this couldn't be farther from the truth. There is strong evidence that you can only reduce your risk to a certain point beyond which there is no further benefit from diversification.

Only add an asset to a portfolio if it adds value, and value means increasing your expected return. This may seem basic, but many investors ignore the simple fact that if an investment is not expected to make money you do not need it whatever the supposedly benefits in risk reduction may be.

2. Negative correlation between assets is preferable

There is this funny misconception that having assets go up when others go down is a good thing. I have even heard this idea being cited by experienced investment specialists. As a portfolio manager, what I definitely do not want is to see hard gained positive returns lost in any way.

Let me clarify further; suppose I have two perfectly negatively correlated assets. Therefore, when one asset gains 5% the other loses 5%, and when one loses 5% the other gains 5%. Do you get where I am going. Every time my total return is zero.

So what I would want is, preferably, low correlation between assets so that is something unexpected happens to one investment, the effects on the others would be as low as possible. Equally, if your objective is to reduce risk, simply reduce exposure and place the cash in a good treasury bond (Malta Government Stock).

3. Diversification offers protection during a financial crisis

One problem with diversification is that during a deep crisis the correlation between most investments moves towards one. That is as events unfold during a major crisis, most markets, whether equity, bond, commodities or real estate will move in the same direction, that is, fall in price; and there is not much you can do except hold on tight. A portfolio (stress on the word portfolio) that has been properly construction should eventually recover.