Diversification is an eternal topic in investment management. Since a portfolio is generally considered to be diversified with 15-20 stocks, you feel pretty comfortable that you are diversified suppose you have 25 stocks and mutual funds in your portfolio, don’t you?
But what if the assets in one portfolio move in the same direction at the same time, that’s is, they are highly related? The hedge you expect by holding a lot of assets is gone. Let’s do some simple exercise.
Suppose we randomly pick the first asset when we enter characters from A to K in the Asset Correlation Analyzer, the assets we select are A, B, C, D, E, F, G, HAL, IBM, JBHT, K.
Let’s check the outcome of the correlation matrix.
It is not only the number of the assets in your portfolio, but how they relate to each other that determines your level of diversification. Ultimately, the risk of the portfolio, or the amount the portfolio return vary, will depend on the extent to which the portfolio holdings move together.