Modern Portfolio theory: The value of diversification

30/08/2017

In 1952, Harry Markowitz wrote an essay titled “Portfolio Selection” that became the basis for Modern Portfolio Theory (MPT). The concept behind MPT is that the assets in an investment portfolio should not be selected individually. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price.

Correlation

Correlation is a statistic which measures the price movements between two assets.

A correlation of +1 indicates that the two assets have a perfect positive correlation. When assets have a perfect positive correlation, the prices move together in unison.

A correlation of -1 indicates that the two assets have a perfect negative correlation. When assets have a perfect negative correlation, the prices move in opposite directions.

The correlation of assets will always lie between -1 and +1.

Using correlation to construct portfolios

To illustrate how correlation works, we will compare three portfolios (A, B & C) and explain how introducing assets that are less correlated can potentially reduce risk (also known as standard deviation) within a portfolio. When a fund has a high standard deviation, the predicted range of performance is wide, implying greater volatility or risk.



By plotting the above results in a graph we can see the effects of introducing assets that are less correlated with more clarity.

The graph shows us the range we would expect the majority of returns to be between, with the red line being Portfolio A, the green being Portfolio B, and the blue line being Portfolio C.



In Portfolio A (correlation of +1.00) the standard deviation was the highest which has caused the data to be more spread out. The factors that influence the price movement for each Australian Shares Fund are essentially the same, and as such, both funds will tend to move in unison i.e. move up together and move down together.

In Portfolio B (correlation of +0.67) the standard deviation was reduced by replacing an Australian Shares Fund with an International Shares Fund. Interestingly, by making this change to the portfolio, the downside risk has been reduced without reducing the upside risk. While they are both share funds within the portfolio, international shares are not perfectly correlated with Australian shares meaning the downside risk is reduced.

In Portfolio C (correlation of 0.00) the standard deviation was the lowest, causing the data to be more tightly clustered. By replacing an Australian Shares Fund with an Australian Fixed Interest Fund the downside risk has been further reduced but the upside risk has also been diminished. The factors that influence the price movement of an Australian Shares Fund are quite different to those that influences an Australian Fixed Interest Fund. Australian shares may benefit from a rise in inflation to provide protection. Alternatively, inflation may lead to a fall in bond prices, potentially reducing total returns on bonds.

Many view portfolio construction as a simple exercise, in which to manage risk, is to not ‘put all your eggs in one basket’. Simply stated, diversification results when you spread your funds across different assets. However, to maximise the benefits of diversification, we need to combine assets that have a tendency to respond differently to market forces.

As the above examples demonstrate, using correlation is one effective way to manage risk within a portfolio. There is no point having a portfolio of multiple fund managers (or shares) if they are all driven by the same underlying factors.

If you are interesting in learning more about Modern Portfolio Theory, or if you are interested in re-assessing your assets to create a more diverse portfolio, speak to your local financial adviser for further insights and guidance.