In the world of investing, we seem to always hear the term, “diversification”. However, I have often found that many do not understand its meaning.

Diversification is a principle that is taken from portfolio theory. Basically, it is a concept that refers to maximising return for a given level of risk. I’m sure most of us can remember the recession of 2008. In that year, many investors, including ‘diversified’ hedge funds, came to the harsh realisation that while they believed their investments were diversified, in reality, they weren’t quite as diversified as they thought.

The underlying concept of diversification is mathematical. That concept is correlation. Let’s take a look at the relationship between correlation and diversification as well as how diversification in its truest form is beneficial.

First, we must understand correlation. It is a mathematical measurement of how faithfully the movement of one parameter (in this case, asset price) follows the movement of another parameter. So, when we look at it in terms of stock price, if we have a correlation of one, we can say that two stocks will follow each other in an identical manner. On the other hand, a correlation of negative one tells us that one stock will behave in the exact opposite manner of the other. If there is a correlation of zero, we infer that that the two prices have absolutely no relationship.

A portfolio that is comprised of stocks that have a correlation of nearly one is a portfolio that we would consider poorly diversified. So, for instance, if we bought stock in the four largest Australian banks (Commonwealth, Westpac, ANZ and National Australia Bank), we would have very little diversification. Why? Because there is a very high correlation between them. In other words, a correlation of close to one. So, if the price of one bank falls, there is a very good chance that the others will follow suit.

There is one advantage in this scenario, however. There is some safety should one of the banks make a mistake. The reason being that all of the banks face share similar risks and are influenced by the same economic variables. So, if one of the banks makes a mistake, there are three others who could have made a good decision under the same circumstances.

We could add a little more diversification in this illustration by buying stocks from other sectors. For instance, we could purchase shares of BHP Billiton and Rio Tinto to increase our portfolio’s diversity. That’s because the correlation between our bank stocks and resources stocks has a lower correlation than the bank stocks alone. We should be aware that while adding ASX stocks has the benefit of increasing the diversification of our portfolio, there will come a point where the improvement hits a plateau and no further advantage may be gained. The correlation between these two sectors’ stocks is because of the fact that they face the same macroeconomic factors up until a point. After that point is reached, the only way of continuing to increase diversity is by purchasing stocks in overseas equities or another asset class.

We have been talking about correlation from a theoretical standpoint. Now, let’s see how this works in the real world.

Many investors, hedge funds and banks in the United States were focusing on the benefits of buying into the housing market in the early 2,000’s. As part of this trend, there was the creation of products known as mortgage backed securities (RMBS). This gave investors the ability to buy into the large Unites states mortgage market.

The risk level of RMBS was assumed to be very low. This was because it was believed that the probability of default by a home owner in the State of New York, for example, had no correlation to the probability of a home owner in Michigan defaulting. It was because of this perception that very high ratings were given to these products by the ratings agencies.

When we look at the reality of the situation however, we need to recognise that within an asset class there will always be some correlation between stocks. In fact, when a crisis hits, we will find that this correlation becomes higher. So, in the 2000’s, when house prices decreased, there were major losses for those investing in RMBS. We learned that the mortgages within the RMBS were indeed highly correlated. It just goes to show us that misjudgements can be made, even by professional investors.

In terms of risk adjusted returns, the largest gains for a portfolio occur when the assets we add to that portfolio have either a negative correlation or no correlation at all with the total portfolio. A significant improvement in the risk with little affect on total returns can be achieved by buying into an asset class that generally has a negative correlation with stocks, such as bonds. Some commodities like gold may be negatively correlated or uncorrelated with stocks.

Now, let’s take a look at the concept of risk. A measure of risk that is used by most financial analysts is standard deviation. Standard deviation measures the volatility of a stock or asset price on a day to day basis. So, if we have a stock whose price hardly varies, that stock would be considered to have a low standard deviation. On the other hand, a stock whose price changes on a daily basis would have a high standard deviation.

Generally, when we have a stock with a high standard deviation, we typically find that here is an increased risk. In other words, there is a higher chance of losing a large amount of an investment if a price falls when we are dealing with a stock that has a lot of volatility on a daily basis. What do we do with this information? We can calculate a stock or assets’ risk and do a comparison to the stocks’ anticipated return.

When we do this calculation we can see that there is a possibility of reducing the standard deviation of an overall portfolio when a stock has a low correlation with the portfolio by more than the anticipated return.

Based upon what we have just discussed, we can see that with a fundamental understanding of diversification, we have the ability to improve our market performance. When broken down, diversification is a concept that is not a difficult one to comprehend. As investors, it is essential that we have very good understanding of this concept and include it in our investing plan when building our portfolio.