The New Rules of Diversification: Correlation Matters

In the ever-changing landscape of financial markets, one principle has stood the test of time: Diversification. Often hailed as the cornerstone of Modern Portfolio Theory, diversification has been a guiding principle for investors seeking to navigate the uncertainties of investing. At the heart of this principle lies the work of Harry Markowitz, a name synonymous with the pioneering concept that has shaped the way we approach portfolio construction.

"To reduce risk, it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little protection than the uncertain return of a single security." – Harry Markowitz

Markowitz introduced diversification as a means to reduce portfolio risk. His work laid the foundation for Modern Portfolio Theory (“MPT”), demonstrating how spreading investments across various assets with low or even negative correlations can effectively mitigate risk. At its core, diversification seeks to minimize the impact of losses arising from an overreliance on a single asset, providing investors with a buffer against market turbulence. The key to MPT is to identify and incorporate assets exhibiting either low correlation or, even better, negative correlation (i.e., move in opposite directions) to each other. Doing so helps investors achieve a balanced mix of investments that seeks to cushion the portfolio against significant downturns while still providing opportunities for growth and creating an all-weather portfolio.

Stating the Obvious: The Hazard of Singular Investments

The inherent risk associated with relying solely on one type of investment becomes easily evident when considering the performance of a long-only stock portfolio. It goes without saying that stock prices can be volatile and influenced by various factors. If all investments are concentrated in long-only equities and the stock market experiences a downturn, the portfolio may likely move in lockstep. In other words, the potential for significant losses is magnified when investments lack diversity.