Correlation Makes Diversification Work

Diversification has been called the "free lunch" of investing. The problem, however, is that most people don't really understand how to diversify their portfolio. They equate diversification with having a lot of different stocks or mutual funds, but if all the funds and stocks are large-cap U.S. stocks there is no diversification.

The secret sauce of diversification is "correlation." All investments go up and down. The level of correlation between two different asset classes is determined by how they go up or down in relation to the other. For example:

* If Asset Class A tends to go up or down at the same time as Asset Class X, they are said to be highly-correlated.
* If Asset Class B tends to go up when Asset Class X goes down, and vice versa, they are said to be inversely-correlated.
* If Asset Classes C and X seem to move up and down in unrelated ways, they are said to be non-correlated.

As an investor, the benefit of having non-correlated or inversely correlated asset classes is that you are more likely to have some investments going up as others are going down. This will dramatically even out the volatility of your investing experience. You may not earn as much when the market is booming, but you also won't lose as much when the market is tanking. Take a look below for an illustration of how this works.

This graphic depicts how two highly correlated investments behave in relation to each other. Whenever Investment A goes up, so does Investment B. And when Investment B goes down, so does Investment A. If your portfolio is limited to Investments A and B, you'll experience the same up-and-down fluctuations and your return will equal the average of the two. An example of two investments that would tend to be highly correlated would be Exxon and Chevron. When oil prices go up, their stock prices tend to go up; and vice versa.

This graphic, on the other hand, depicts how two negatively correlated investments behave on a relative basis. When Investment E goes up, Investment F goes down. The opposite is true as well. By combining the two investments you dramatically reduce the volatility of the portfolio. An example of two non-correlated investments would be Exxon and JetBlue. When oil prices go up, Exxon stock tends to increase while JetBlue's tends to decrease.