Ken’s Latest Posts

ramcreations/shutterstock

If you’re going to be diversified, it’s important to understand correlation.

One of the best tools that retirees have at their disposal to control risk is diversification. Remember the old saying: “Don’t put all of your eggs into one basket.”

That’s good advice. If you drop the basket you could possibly break all of your eggs. It’s much better to spread your eggs out into several different baskets, that way if you drop one, you’d still have a few more. But, what if you spread your eggs into a variety of baskets then tried to carry them all at once and dropped them all? You could still break all of your eggs. It may be more prudent to only carry one basket at a time and have the others baskets stored in a safe place. Actually if the stored baskets were all in the same location, the eggs could still get broken if something occurred at that place, like an earthquake. It would probably be best to store the baskets in safe but separate locations.

If you’re going to have a diversified portfolio, it’s important to understand the concept of correlation and the different types of risk investors face. Company specific risk, or nonsystematic, risk is easy to control through diversifying. Instead of putting all of your funds into one stock, you could purchase an index fund and spread that risk over 500 stocks. You could diversify further by adding more stock index funds, but there is a point where you don’t get much more diversification because many of the major stock indexes are highly correlated. Asset classes with high correlation to one another may behave in a very similar fashion throughout any market cycle.

A properly diversified all stock portfolio should have exposure to large-, mid and small-cap funds, have both growth and value styles and have international exposure as well. That includes both developed and emerging markets. Retirees should be aware that even a very well diversified stock portfolio can be subject to broad market risks like geopolitical and economic events.

Retirees concerned about risk can always diversify by adding other asset classes like bonds. Bonds don’t behave just like stocks, right? The answer to that is that it depends on the type of bond. Just adding a bond fund won’t necessarily provide much more diversification. You need to check the correlation between your bond funds and your stock funds. Treasury bond funds provide diversification because they have a negative correlation. Investment grade corporate bonds also tend to help spread risk due to a very low correlation. High-yield or junk bonds on the other hand don’t spread risk nearly as much because they have about a 75% correlation to the stock market.

If you have a portfolio that consists of stocks and bonds and want further diversification you can consider adding other asset classes that have a low correlation to the stock market. Real estate, precious metals, energy and agricultural products can be a part of your portfolio and can help spread risk even more.