What is an Uncorrelated Investment Portfolio? | Importance of Non-correlated Assets in Portfolio Diversification

Stocks, Mutual Funds, Fixed Deposits, Bonds, Real estate, Gold etc., are various Asset Classes that are popular among the investor community.

All of us would like to invest in as many Asset classes as possible. Am I right? But why? Because, we want to spread our Capital across different asset classes to reduce the overall investment risk. Diversification ensures that by not “putting all your eggs in one basket,” you will not be creating an unwanted risk to your capital. 

Let’s consider a scenario – An young man who has completed a Graduation course plans to do his Post Graduation in MBA. He decides to opt for dual specialization in – Marketing (Major specialization) and IT Systems (minor). He believes that by graduating with two specializations he can reduce the risk of not being placed in a job. Also, a marketing specialist with good knowledge in IT systems will have an edge.

This young man completes his MBA (dual specialization) and gets placed in an IT company as Business Development Manager. He decides to start investing for his long-term financial goals in both Equity, Debt & Gold Asset Classes in the ratio of 50:30:20. He invests 50% of his investible surplus in Equity Mutual Funds, 30% allocation goes to EPF+PPF and the remaining 20% in Gold ETFs.

He believes that by investing in a well diversified portfolio with uncorrelated Asset classes can mitigate the risk. He aims to achieve decent inflation adjusted positive returns but with a lower level of risk.

What does he mean by an ‘uncorrelated asset classes’??

Let’s now understand – What is correlation and uncorrelation? What is an uncorrelated investment portfolio? What is the significance of having non-correlated Asset Classes in your portfolio?

What is Correlation and Uncorrelation?

From an investment perspective, Correlation indicates how one Security or Asset class moves relative to another, either up or down. A perfectly correlated asset classes have correlation of 100% or +1.

Conversely, when the value of securities or Asset classes moves in opposite directions, they are negatively correlated (Uncorrelated) having a negative correlation of 100% or -1.

So, when two assets move in the same direction together, they are considered to be highly correlated. When these asset classes move in the opposite direction, they would be negatively correlated.

For example : Many a time, we notice that Equities (Shares) and Gold prices tend to move in ‘opposite’ direction i.e., these two asset classes are negatively correlated.

Uncorrelated Investment Portfolio Holdings & Importance

Portfolio diversification can be achieved by investing in different Asset classes. But, ‘how these Assets are related’ should also be given more importance.

Adding negatively correlated assets in your portfolio can reduce the risk considerably. The best asset allocation comes from combining negatively correlated assets.

“Low correlation can reduce the volatility of your investment portfolio without necessarily affecting the expected level of return.”

uncorrelated investment portfolio sensex gilt gold asset classes risk return
(Source : Moneycontrol.com)

The above image gives us an idea about how Gilt Index (Govt Securities), Sensex and Gold prices have performed over the last many years.

You can notice that during the periods of negative returns from Equity market (Sensex), Gold has given positive returns. The same can be the case with Gilt/Bonds vs Equity markets.

That means, we can infer that Equity and Gold are negatively correlated assets. Equities and Bonds are negatively correlated assets.

Below are some of the important points that we need to keep in mind regarding ‘Portfolio Diversification’ with non-correlated assets.

  • Low correlation can reduce the volatility of your investment portfolio without necessarily affecting the expected level of return. But, it does not take-away the ‘RISK‘. Your investments are still subject to various risks.
  • It is next to impossible to identify ‘perfectly‘ uncorrelated Asset classes.
    • For example : We have discussed that Stock prices and Gold prices are negatively correlated. But, during November 2005 to November 2007 (see above image) gold returns had a high positive correlation with equity, as they moved in the same direction.
    • While gold had a negative correlation with Sensex from June 2011 till recently.
  • We need to consider longer periods to understand the correlation of Asset Classes.
  • Note that a portfolio with negatively correlated assets can’t guarantee higher returns. The key point is – the highs won’t be as high, but the lows won’t be as low, which can lead to a more consistent risk-adjusted return.
  • Also, being uncorrelated (among asset classes) alone is NOT enough. It is very important that the asset/stock in question has an expectation for POSITIVE returns in the long term.
    • For example : Merely holding your Cash (Currency) as an asset class in your long-term portfolio does not serve the purpose.
  • The concept ‘uncorrelation’ should also be applied within the same asset class, manager styles, sectors of asset classes and even securities within the sectors.
  • Diversification among asset classes is good, but that does not necessarily mean to venture into investment avenues that you do not understand and are highly speculative in nature.
  • The quantum (%) of Asset allocation also matters a lot when constructing your investment portfolio.
  • An investor needs to review his/her portfolio and try to -re-balance it whenever it is required.
  • Kindly understand Correlation Can Change. The relationship between two Asset classes can change due to various economic factors and/or business cycles.

Despite investments becoming more highly correlated, smart diversification can still reduce the risk and increase the return of your investment portfolio.

While history can’t predict what will happen in the future, the various Asset classes still tend to perform differently and well in times of crisis also, and the gains of one can cushion the losses on another. So, you need to find a mix of investments that suits your risk tolerance and long-term investment goals. Cheers!

Continue reading :

  1. My New Mutual Fund Portfolio | My Equity MF Investments
  2. What is Portfolio Tracking and Why Should I do it?
  3. List of all Popular Investment Options in India – Features & Snapshot

(Image courtesy of Sira Anamwong at FreeDigitalPhotos.net) (Post first published on :20-August-2020)

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