Asset Class Correlations
Trust Management Educational Series
Diversification is an often touted and misunderstood investment principle.
Diversification means splitting funds among a group of investments instead of concentrating funds in a single asset, single asset class, or highly correlated asset classes.
Asset class performance varies over time and is not easy to predict. A mix of asset classes is more likely to meet an investor’s goals. Different asset classes perform differently; combining them provides better risk/return characteristics.
Asset Class Diversification
Every asset class has risk and return characteristics and a measure of correlation to other asset classes. By finding asset classes that are negatively correlated we can reduce our overall risk.
What is negative correlation of asset classes?
Negative correlation simply means that most of the time, assets classes produce opposing investment returns. For example, New Zealand shares and New Zealand bonds are negatively correlated.
The chart below plots the NZ share and NZ Bond returns over a time series.
You can see that there are very few plots for months where both shares and bonds produced a negative return.
Doesn’t diversification just average return?
The chart below shows that an investment portfolio 100% invested NZ equities is expected to produce a 9% return, with 12% risk, an investment portfolio 100% invested in bonds is expected to produce a lower return 5% but with less risk 4%.
The chart then plots the expected risk and return of investment portfolios with a mix of bonds and equities. By adding some equities to a bond portfolio, we can obtain a higher return with less risk (Point M).
Want to know more?
We use measures of risk, return and correlation to determine the most efficient investment strategy/asset allocation for our clients on what is referred to as the Efficient Frontier.
Trust Management can provide advice to charities about managing their investment portfolios and setting a risk profile that reflects their investment objectives.
If you have any questions, or would like to know more about the degree of diversification in your investment portfolio, please do not hesitate to contact John Williams on (09) 550 4046.
This paper seeks to provide some detail and explanation about diversification. The paper aims to provide a basic oversight of the topics mentioned, using simple terminology in easy to understand language. The paper is not intended to be the definitive guide on diversification. We recommend investors seek advice before investing.