Diversification and correlation

Diversification means spreading your money so that no single loss can sink your portfolio. It is often called the only free lunch in finance — you can reduce risk without necessarily reducing return.

Diversification is about correlation, not count

Ten technology stocks are not ten bets; they are one bet on technology. What matters is correlation — how closely investments move together, from −1 to +1. Combining assets with low or negative correlation is what lowers the swings of the whole portfolio.

Across asset classes

Over the past decade, US stocks, long Treasuries, gold and the US dollar have had low or even negative correlations with each other. A portfolio holding all four has been far smoother than any one of them. You can see the current numbers in our correlation matrix.

Across strategies

A less obvious source of diversification is the strategy itself. A trend-following strategy that moves to cash when a market falls behaves differently from simply holding that market. In our research, the 30 trend strategies were much less correlated with each other than the 30 markets behind them — diversification that comes from the process, not just the assets.

The catch

Correlations are not stable. In sharp sell-offs, many assets fall together, exactly when diversification is needed most. And a diversified portfolio always holds something that is lagging — which tempts investors to abandon it. Discipline matters as much as the mix.

Key takeaways

• Diversify across things that do not move together.
• Mix asset classes and, ideally, strategies.
• Expect correlations to rise in crises.
• Stick with the mix — something will always be lagging.

By Dr. Harry Hamann · 5 min read