Tuesday, September 7, 2010

Beware of Correlation Risk

I've long touted the benefits of diversification - spreading your "eggs" (assets) over many baskets (asset classes/securities) so that the destruction of one does not bring down your portfolio of "eggs" as a whole. One thing Gen Y must keep in mind is that there can be plenty of correlation risk in the assets that you hold. When the financial crisis hit in late 2007, investors realized that when both the financial markets and economy take a dramatic turn for the worse, a majority of assets are going to suffer together. As a result, they will likely move in tandem for a decent amount of time before the correlations begin to fade as the problems clear up.

Thus, take today's post as a quick reminder to avoid buying too many assets that have strong correlations. By this, I mean that it's a good idea to spread your money around a variety of different asset classes whose correlations may not be that strong. For example, if you buy the Vanguard Total Stock Market Index (VTSMX) for exposure to domestic equities, it may not be a bad idea to add an international index fund which traditionally has lower correlations with domestic equities. As we saw in 2007, this strategy won't always be perfect, but as a disciplined long-term investor, it will help shield you from any short-term blip dragging your broader asset allocation down for the long-term.

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