Visual Correlations Part 1

I like pictures.  In my copious spare time I’m a black-and-white photographer.  I use film.  I have my own darkroom.  Maybe that’s why I think of correlations in terms of diagrams instead of just as numbers.

Correlations are the key to understanding how diversification lowers financial risk, and diversification is one of the simplest and oldest ways that humans have managed risk.  By spreading around the chances of bad things happening, you lower your risk.  “Don’t put all your eggs in one basket” is obvious, even to children. Most importantly – it works.  Financial portfolio management implements this advice by applying investment guidelines like “no more than 5% invested in any one company.”  This automatically forces the investments to be spread over at least 20 different companies.

But what happens if those 20 companies’ values/stock prices start rising and falling together – the equivalent of putting your eggs into 20 baskets and then carrying them all down a steep hill?  The relevant question then becomes ‘How much do you reduce your risk by spreading the investments across many companies if their stock prices are related?’  The short answer is that it all depends on the correlation between the assets.  If two stocks are highly correlated, then putting money into the second stock doesn’t lower the overall risk at all.  But if the two stocks are uncorrelated, then you can reduce your risk substantially by investing in the second stock. Read more of this post