Diversification is a process of minimising risk and maximising returns through investing in different asset classes. In this process itself, when diving deeper, you understand that investment has to be made in asset classes that are not closely related to each other because of utilising the features of every asset class in an optimised way.
What is an ideal diversification correspondence with correlation?
A diversified portfolio for a moderate to low-risk profile investor is optimised when it comprises stocks, debt, and gold. Stocks help you in giving drastic growth but also have a significant risk of losing capital in the case of an internal or external financial crisis. Debt instruments help you in protecting capital invested. Lastly, when the stock market tends to fall in the case of a disturbed economic situation, investors are more likely to buy gold to save their capital.
When you look deeply, you notice that every asset moves in a different direction in one scenario and serves different purposes. Here comes the concept of correlation.
What is correlation?
Correlation is a statistical measure that describes how two or more variables move in relation to each other. In the context of investing, it is used to analyse the relationship between different asset classes in a portfolio. This means how much one security market gets affected due to one security market. If one asset performs poorly, other assets give better returns to offset the negative returns.
Understanding correlation in the context of investment
Take the example of current scenarios. Stocks are currently giving negative returns, but fixed-income securities are giving stable returns, as per banking norms. Even the interest rates on FDs are increasing due to the RBI's hike in repo rate.
These two securities are not related to each other, which is why including both of these instruments indicates a better investment decision, as FD is offsetting the negative returns of stocks. When the market recovers and starts performing well, it will give you better returns than FDs.
How does correlation work in crafting investment portfolios?
The less the instruments are correlated, the more profitable the portfolio is for you. Let's understand it through an example:
Person A has created a portfolio by investing in stocks of different sectors—50% in IT stocks, 30% in the automobile sector, and the remaining in the healthcare sector.
Person B has created a portfolio by investing in a mixture of stocks and fixed-income securities—50% in the stocks, 30% in debt mutual funds, and the remaining in FDs.
Who has the safest portfolio?
Now, who do you think has the safest portfolio? Obviously, person B, because B has invested in less-related securities than A. Stocks will tend to perform more or less similarly in the case of a global-level financial crisis, like the scenarios we are currently facing. When stocks tend to fall and start giving negative returns, fixed-income securities will give you more stable returns than stocks, as income from the instruments is fixed and less affected by the market.
One thing to keep in mind is that every investor has their own set of risk profiles and investment horizons. No ideal investment portfolio exists for you by following generalistic advice. Investing in the market is totally associated with risk. A well-diversified portfolio helps you achieve your financial goal, which you cannot afford to risk.
Anushka Trivedi is a freelance financial content writer. She can be reached at anushkatrivedi.com