Understanding and managing portfolio and investment risks within an investor’s basket of investments is paramount in ensuring returns commensurate with the risks being undertaken. One of the crucial factors within portfolio risk management is understanding diversification, and the correlation of returns between underlying securities.

Balancing risk and expected return is cumbersome for any investor considering any array of investment choices and decisions. Portfolio diversification could in essence reduce risk; the lower the correlation between returns from different securities in a portfolio, the greater is the incremental benefit from the diversification within a portfolio.

The importance of viewing a portfolio of investments as a whole investment in itself (pretty much the way asset managers view the risk of mutual funds (or collective investment schemes) instead of focusing on individual holdings is vital. Since diversification can help reduce risk without impinging on the portfolio’s expected return, an important consideration an investor must make is the assessment of assets and their contribution to the risk and return of the overall portfolio.

Harry Markowtiz, an American economist most famous for his work in Modern Portfolio Theory, concluded that “portfolio risk is reduced by diversifying across assets as long as the returns of combined risky assets are not perfectly positively correlated.” The study, based on an analysis carried out on the underlying constituents within the S&P500, indicates that it is difficult to find equities that are consistently uncorrelated as the large majority of the components generally display some degree of positive correlation, despite forming part of different sectors.

We have all heard the saying of not to put all ones eggs in the same basket, which taking cue from the study above which basically means not to invest entirely in one asset class, such as a 100% exposure to bonds, or 100% exposure to equities. It thus follows that in order to diversify further, other asset classes need to be considered. It has been statistically proven that diversification (spreading investments across more than one asset class) reduce overall portfolio risk due to the non-linear correlations between asset classes. However, it is worth mentioning that correlations are extremely dynamic and correlation of returns between asset classes can vary from time to time.

Correlations between various assets across a portfolio have a direct impact on the level of diversification (and risk) of any portfolio; the more uncorrelated the investments, the lower the risk of the portfolio. Having said this, while correlations between a portfolio’s assets are crucial to diversification, there are other important factors which can also impact portfolio diversification, such as the volatility of returns of different assets as well as the different weights for the different assets within a given portfolio.

Asset and Investment Managers around the world, whose job is to run and manage mutual funds (or collective investment schemes) of differing sizes of varying themes view the concept of portfolio diversification and the correlation of returns within a context of a portfolio (or fund) as pivotal and a fundamental part of their risk management process. Skilled Fund Managers constantly review the inherent risks within a fund, and ensure that the expected return of a fund is commensurate with the risk being undertaken and continuously monitor such correlations in order to achieve the best results possible. This is a highly complex process, and this is why a large number of investors worldwide prefer to invest in mutual funds (rather than in direct securities) as they offer an investor a diversified exposure to the markets, whose risk is being managed on an ongoing basis.

Disclaimer:

This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.