Avoiding all eggs in the same basket

Get the full effect of diversification by considering the correlation of your assets with these tips from Morningstar's Director of Investment Research, Ian Tam

Ian Tam, CFA 1 April, 2020 | 2:49AM

 

 

Ian Tam: When you think about asset allocation, it's often useful to look at the correlation between asset classes. Correlation is a measure of the degree to which two asset classes move in relation to one another.

If you have a look at the chart on the screen here, this is a correlation matrix. And when you see a correlation that's close to 1, that means that historically two asset classes move in a very similar way. A correlation closer to negative 1 would imply that historically they've moved in opposite directions. So, to reduce risk, it's useful to pick funds that have low or negative correlations to one another to get the full effect of diversification.

For example, let's look at this chart here which illustrates a portfolio that is 40% U.S. equities, 35% global fixed income and 25% Canadian equities using the category averages. The thin lines will show the performance of the individual asset classes, while the thick red line shows you the performance of the portfolio when you combine all those asset classes together in the ways that I just mentioned. The combination of those three asset classes gives you a total return that's somewhere in between the components that make up the portfolio. So, by combining asset classes, you can build a portfolio that fits your specific risk profile.

So, what is the optimal asset mix? It actually depends on several different factors including your financial goals, resources, risk profile and your time horizon. So, in short, your whole financial situation. Retail investors that don't wish to take on the burden of accurately calculating the ideal asset mix can consider using target date funds. These are a group of multi-asset funds which will automatically put you in a risk appropriate set of underlying portfolios and more importantly, will de-risk you as you close in on that target date. It's also recommended to talk to an investment professional or an advisor to help you make sure that your asset allocation is appropriate for your risk tolerance.

For Morningstar, I'm Ian Tam.

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Ian Tam, CFA  Iam Tam, CFA, is Director of Investment Research at Morningstar Canada. 

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