At Tradition we often talk about the benefits of adding uncorrelated investments to your portfolio and how they can help in reducing portfolio risk and in building a portfolio with a smoother (and less stressful) ride. However, we understand that the concept of uncorrelated asset classes and their impact on a portfolio can be difficult to understand. Therefore, we have prepared a model graph that we believe helps explain the concept visually in a way that is easier to grasp.
To visualize this, we have set up a series of six simplified assets that assume a 0% correlation to each other, or in other words, assets whose returns are completely independent of each other. (The real world does not quite operate like that but to explain the concept we have made that simplifying assumption). All 6 model assets have identical characteristics to the others: an expected return of 7% per year and an expected standard deviation (i.e. risk) of 10%. The hypothetical growth of these investments over 20 years are displayed as the colored lines on the graph below. As you can see, the outcomes vary dramatically depending on the random future events even though they all have the exact same expected returns and expected standard deviations.
However, as demonstrated in the model portfolio graph below, if you have a portfolio that includes all 6 of these assets in an equal proportion, the portfolio value changes are much less extreme, with significantly less zigzagging, and the return is more predictable – this is represented by the thicker black line below.
Moreover, the returns from the combined 6-asset portfolio are much more stable, with much smaller losses than any of the individual asset classes has on its own. The randomly generated returns for the 6-asset portfolio generated a maximum loss of $1,852 in any one year. In contrast, the worst loss in any single asset portfolio in one year was $40,508, and even the single asset portfolio with the smallest one year loss still generated, in its worst year, an $11,288 loss. Diversification of uncorrelated assets allows an investor to build a portfolio that has smaller overall drawdowns and more stable, predictable returns.
To look at this another way, we have graphed the 6 assets showing the yearly percentage returns. As you can see, the colored lines zig and zag wildly, showing a great deal of volatility with little predictability. However, the combination of all 6 assets into one portfolio, while still generating some variation, creates a more stable and predictable return as shown with the black line.
Disclosure: Tradition Capital Management does not make any assertions, estimates or guarantees about future results. At a given time, any risk asset class or asset may lose value and result in substantial losses. Inflation risk is an additional risk for financial assets. Expected returns, expected yield, and expected risks are not forecasted returns or risks, but are only statistical definitions for modeling purposes.
Comments are closed.