Diversification is one of the most commonly techniques used to minimize investment risk. One of the best ways to think about diversification is the same way you would think about an oil tanker. George Soros says it best:
GEORGE SOROS: Markets are inherently unstable, or at least potentially unstable. An appropriate metaphor is the oil tankers. They are very big; and therefore, you have to put in compartments to prevent the sloshing around of oil from capsizing the boat. The design of the boat has to take that into account..
If something goes wrong with one of the oil tanks the other oil tanks are compartmentalize so the whole vessel does suffer damage. This is one of the easy ways to think about diversification.
A way to provide diversification in a portfolio is to find asset classes that are not correlated. Correlation – a statistical measure of how two securities move in relation to each other. Correlation can be deceiving when it is only viewed as static correlation. For example if we looked at the correlation of the S&P 500, S&P GSCI, FTSE REIT, 10 Year Treasury Note and the MSCI EAFE index in a correlation matrix we could see which asset classes are uncorrelated. In Chart A below, we can see the correlation for these asset classes . The S&P 500 has had a low correlation to 10 Year Treasury Notes and the S&P GSCI index from 1995 to 2011.
If we use a 12 month rolling Dynamic Correlation with these same asset classes we can see in Chart B that in the latter part of the Dynamic Correlation that both the 10 Year Treasury Note and the S&P GSCI Index have become highly correlated with the S&P 500. This gives a different view as opposed to the view presented by static correlation that shows the asset classes weren’t as heavily correlated. We can also see the other asset classes and how they are correlated to the S&P 500 in Chart C.
Another way correlation is not properly used is that static correlation isn’t divided into positive returns and negative returns. The question of what happens when a particular asset class has negative returns. Do other asset classes move in the same way when they are experiencing negative returns or do they move in an opposite way or vice versa for positive returns. Even though this concept seems so easy I have never encountered it yet in any trading or investing documentation. The only place where I have heard mentioned is from Niels Kaastrup and Tushar Chande of Rho Asset Management.
[pullquote]Diversification is one of the most commonly techniques used to minimize investment risk. [/pullquote]
If we were to take a look at how these asset classes from Chart A act when they produce negative returns or when they produce positive returns, we are able to see if different asset classes move in tandem if they produce negative returns or move in tandem if they produce positive returns. Chart D shows static correlation for negative returns and Chart E shows static correlation of positive returns.
We can see that MSCI EAFE moves in tandem with the S&P 500 when these asset classes produce negative returns with a .81 correlation. When these asset classes have positive returns they produce a lower correlation of .61. As well the FTSE REIT has a higher correlation of .57 with the S&P 500 when both these assets produce negative returns as opposed to them a lower correlation of .30 when both of these asset classes produce positive returns. This way of looking at correlation is also extremely helpful when comparing asset managers against each other or comparing fund returns to Beta products.
 Ferguson, C. (Director). (May 16, 2010). Inside Job [Motion Picture].