A Window to Your Assets
You could approach the problem like an artist. Grab the charcoal to start a sketch. When the outlines are in place, you can fill in shades and colors with paint or crayons.
Building bricks
Suppose you are allocating funds across several portfolios, rather than in just one individual account. If you have multiple accounts, you may find the different institutions holding them all vigorously urging you to consolidate them — preferably under their own roof. There is an indisputable logic to streamlining and aggregating in order to obtain an integrated picture of what you own and more easily rebalance. But remember that each of the brokerages or fund families is highly motivated to bring the most possible money into their own camp!
As you construct your holistic portfolio, diversification is still the holy grail for reducing risk. The ideal number and arrangement of bricks is the magic ingredient that washes away the random movements of the separate holdings. An optimal combination of investments, whether representing large caps, small caps, or growth, defensive, domestic or global themes, together should produce a high degree of diversification.
Superimposed on top, you and your adviser also need to tailor the components to reflect your own personal risk profile. This will include your age, time frame, risk tolerance and objectives. In the medium term, are you saving toward a house or for children's education? In the long run, up-and-down volatility becomes less important, as most markets tend to self-correct.
Never neglect the psychological side. Investors are more likely to stay the course and not succumb to volatility, as long as they can regard their portfolio as a single unit and not a group of parts. It is impossible to avoid all market risk, aka systemic risk, that comes with the basic territory of investing. There is little to be done to control that systemic risk, which manifests in inflation rates, foreign exchange rates, interest rates, war and political instability.
Correlations march to the same beat
Nonsystemic risk, tied to a particular business or company, is another story. Correlations are a useful tool for measuring it. They are mathematical expressions for predictive relationships.
Are prices moving in similar or opposite directions as a reaction to outside trends? For instance, when days are sunny, drugstores sell a lot of sunscreen and few umbrellas. When pilots strike, airlines suffer, but railways and cruise lines may reap the benefit.
The principle is that investors want to load up on assets that react to industry trends along different paths in order to boost their risk/return success. The aim is to find stocks that respond to such different forces that there is little chance they will synchronize at the same moment in the same direction.
Zero correlation means there exists no predictive relationship between a pair of assets. The correlation scale then proceeds from -1.0 to +1.0, whereby the highest number of +1.0 indicates that one element's gains are completely offset by the other's losses. If you are risk averse, you might seek the lowest feasible correlation, such as a number below 0.7.
Hidden correlations
You can certainly measure correlations to calculate a less risky mix of stocks. But in real life, they are always jiggling, never staying constant. For instance, correlations increased in Europe with the advent of the European single market in 1993 and again with the euro in 1999. Emerging markets today may narrow correlations, as they become more integrated with global asset movements. Even the relationship between equities and fixed income, a bedrock of rebalancing, can teeter when large hedge funds are forced to unload assets in both classes to plug large losses.
Your investment manager can help you build a safer portfolio based on an overall risk/return ratio. You will learn how professional funds use statistical techniques to study how particular pairs of assets have interacted in the past.
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