In our previous article, we went over the fundamentals of volatility and correlation. Quick recap: Volatility is the amount an asset’s price or value moves up and down over a period of time. Correlation is a measure that describes the relationship between two securities. Highly correlated securities usually move together. And securities with low correlation, usually don’t. When investing, you want to understand how volatile your assets are, so you know how much risk you’re taking on. Then, make sure you’re diversifying your assets so that a single event in one industry or part of the world doesn’t impact them all.

Now we’re going to dive into the world of diversification. When looking at asset classes, it’s helpful to break them down into industry sectors because ultimately, you’ll want to diversify among different types of industries.

The first question investors ask is, “Is it really diversified?” On a high level, a diverse asset mix is comprised of cash, fixed income, and stocks. Looking at it in more detail, a diverse asset mix will generally include cash, government bonds, corporate bonds, preferred shares, energy, industrials, real estate, consumer discretionary, financials, information technology, telecom, consumer staples, healthcare, materials, and utilities. Quite a list, right? You can see how a single event in one industry is not likely to impact them all.

Is it Really Diversified?

Traditional Ways to Look at Diversification

Of course, as you’re building your portfolio, you’ll likely invest in more than one asset from the same industry. While this makes sense, keep in mind they will be highly correlated. For example, let’s take a look at TD Bank and Royal Bank. Their peaks and valleys move in tandem with each other which means when the going’s good, both of them will be up. But on the flip side, expect them both to come down simultaneously.

Some things we expect to move together

Source: Thomson Reuters

Now that we’ve covered diversifying among different industries, let’s talk about correlations between assets in different industry categories. Yes, it feels like a trick question but it’s actually quite simple. Let’s compare Finning to another financial service, Canadian Western Bank. But unlike Royal Bank, they’re highly correlated. That’s because Canadian Western Bank lends to energy companies and employees of energy companies, and Finning sells equipment to companies in the energy sector. Clearly, in both cases, their success is dependent on the energy sector’s success. The key takeaway here is that correlations can be caused by elements outside of operating in the same industry and it’s important to understand the underlying drivers of the business or asset.

Others we don’t

Source: Thomson Reuters

Now that we’ve covered diversifying among different industries, let’s talk about correlations between assets in different industry categories. Yes, it feels like a trick question but it’s actually quite simple. Let’s compare Finning to another financial service, Canadian Western Bank. But unlike Royal Bank, they’re highly correlated. That’s because Canadian Western Bank lends to energy companies and employees of energy companies, and Finning sells equipment to companies in the energy sector. Clearly, in both cases, their success is dependent on the energy sector’s success. The key takeaway here is that correlations can be caused by elements outside of operating in the same industry and it’s important to understand the underlying drivers of the business or asset.

But some things are not what we expect

Source: Thomson Reuters

Here’s another watch out. Ever heard of non-investment grade bonds? They were formerly known as junk bonds and are lower-quality bonds that are priced based on credit quality since their risk is related to repayment. While bond prices are normally based on interest rate movements, it’s not the case here because the issues that impact repayment are more closely related to stock prices than interest rates. As a rule, non-investment grade bonds move more like stock prices than bond prices. We can’t stress the importance of that correlation more.

There you have it. Now you can start investing more strategically and with more accurate expectations.

A few things to keep in mind as you move forward. There will be moments that will defy expectations, often caused by a downturn in the market. When that happens and panic sets in, there’s a tendency to eschew logical thinking and sell, which results in an increase in correlations across the board. Understand that if it’s happening to you, it’s happening to everyone.

By controlling the volatility in your portfolio and making sure you won’t have price swings greater than what your financial wherewithal can absorb, you can reduce the impact an extreme downturn event will have on it. Thus, allowing you to increase your chances of success in reaching your investment goals.

The best strategy you can have is to plan for the worst and hope for the best.