Investment Correlation

Do you enjoy working with the landscape around your home?  If you do, your continually trying to maintain the trees and plants while always thinking of what else you can add or change to make the place look even better.

A few years back, my wife and I learned a valuable (and expensive) lesson.  It was springtime and we needed to plant some new trees around our small back-yard pond. Since our pond is surrounded by river rock, our goal was to select trees that would give the “feel” of being in the mountains. With that in mind, we opted to plant evergreens.

Armed with a plan, we visited the local nursery and came home with five trees.  Two were blue spruce, two were Ponderosa Pines and another was a Scotch Pine.  Several hours and a lot of  digging later, we had five new trees in the ground.

The ensuing summer brought a significant drought.  Although we watered as much as possible (it almost required a second mortgage to pay the water bill), we noticed that the Ponderosa pines were looking sickly.  Not to worry we thought…even if we lose the Ponderosa’s the other pines were a completely different species. Surely they would survive. Wrong!….Slowly but surely, all of the new evergreen died.. 

The following spring, we again visited the nursery.  We shared our tree-killing tale with the owner, asking if he knew what went wrong.

“It’s really quite simple”, he told us.  “Although you bought three different species of trees all three kinds were still evergreens.  What killed one species killed the others as well.”

Our horticultural mistake taught a valuable lesson – although we had diversification (three different species of trees) it made little difference since we had too much “correlation” (what happens to one will most likely happen to all).

Like evergreens, investments held in a portfolio can also be subject to considerably greater risk when there is a high degree of “correlation” between the various investment vehicles. This is an extremely important consideration for every investor, but it’s rarely understood or addressed by most folks. 

A typical portfolio is comprised of many different types of investments.  We’ve all heard about diversification and the benefits it offers.  Diversification is the idea that you never put all of your eggs in one basket.  If one investment should falter, diversity among your investment holdings serves to buffer the negative effect on your portfolio.  While diversification is great, there’s more to the story.  The degree to which investments are “correlated” can have an even bigger impact. 

Meet Jimbo, the object of our case example….Jimbo is a typical guy who owns a pretty standard investment portfolio.  He owns three mutual funds (each invest in stocks, seeking capital growth), an assortment of utility stocks (six different utilities issues, seeking income from dividends) and two bond funds (also purchased as a source for income). Superficially, it sounds like he’s reasonably diversified.

Now consider what can happen to Jimbo’s portfolio if economic events turn ugly.  Suppose the federal reserve begins to raise interest rates.  If that occurs:

It would appear that Jimbo’s portfolio is not as secure as it first appeared.  Although the overall portfolio was adequately diversified (he owned many different types of investments), the correlation between those investments was far too high.  To state it simply, the performance of each of Jimbo’s investment holdings would tend to react in a similar manner as rates moved higher..

It’s important that every investor take a moment and evaluate the degree of correlation between his/her various investment holdings. If you’ve never done so, it’s wise to make a list of the “what if” scenarios (changes in domestic US or global economic conditions, political or social changes, etc. ). Next, try to imagine the effect that each of those events would likely have on each of your investment holdings. Finally, determine how many of your investments would most likely react in a similar way to changing events. This exercise will offer a snapshot of the degree of correlation between the investments within your portfolio.  If required, you can then realign the portfolio (exiting some investments while initiating others) to create less correlation.  By taking a few minutes to evaluate your holdings in this manner, you may save yourself considerable grief down the road.