Diversification Limits: Portfolio Volatility & Positive Correlation

Imagine you are creating a recipe for a perfectly balanced investment portfolio. One key ingredient in any good recipe is diversification, which is essentially spreading your investments across different assets. The goal of diversification is to reduce risk, or what we call volatility in the investment world. Volatility is just a fancy term for how much your portfolio’s value might bounce around. We generally want to minimize these bounces, or at least control them, so our investment journey is smoother.

Now, let’s think about how different assets relate to each other. This relationship is called correlation. Correlation essentially measures how much the prices of different assets tend to move in the same direction. If two assets are positively correlated, it means that when one goes up, the other tends to go up as well, and when one goes down, the other often goes down too. Think of it like siblings; they might have their own personalities and lives, but they often share similar traits and experiences.

Perfect positive correlation would be like identical twins doing exactly the same thing at the same time. In the investment world, this is rare, but assets can still be positively correlated to varying degrees. For example, stocks in the same industry, like technology stocks or energy stocks, tend to be positively correlated because they are often influenced by similar economic factors.

Now, back to our recipe and diversification. If you diversify your portfolio by adding assets that are perfectly negatively correlated, meaning they move in opposite directions like a seesaw, you can theoretically eliminate all portfolio volatility. When one asset goes up, the other goes down, and if perfectly balanced, they can cancel each other out, leading to a very stable portfolio value. This is like having an amazing balancing act in your recipe.

However, in the real world, finding assets that are perfectly negatively correlated is incredibly difficult, and especially not across many assets. More commonly, assets tend to be positively correlated to some extent. This is where the question of a lower limit to volatility comes in.

When you diversify across many assets that are all positively correlated, you do still reduce portfolio volatility compared to holding just one or a few assets. Think of it like this: if you only invested in one stock and that stock’s price suddenly dropped significantly, your entire portfolio would take a big hit. But if you spread your investments across many positively correlated stocks, and one stock drops, the impact on your overall portfolio is lessened because you have other stocks that may not have dropped as much, or might even have increased slightly. Diversification acts as a cushion.

However, because these assets are positively correlated, they tend to move in the same general direction due to underlying common factors. These common factors could be broad market trends, economic conditions, interest rate changes, or even investor sentiment. Because of these shared influences, even with extensive diversification across positively correlated assets, you cannot eliminate all portfolio volatility. There’s a limit to how much you can reduce risk through diversification in this scenario.

Think of it like trying to reduce the waves in a bathtub by adding more boats. Even if you have many boats, they will all still rise and fall together with the tide. The tide represents the systematic risk, or market risk, which is the risk that affects nearly all assets to some degree and cannot be diversified away. Positive correlation reflects the influence of this systematic risk.

Therefore, the theoretical lower limit for portfolio volatility when diversifying across many positively correlated assets is not zero. You can reduce volatility significantly through diversification, but you will always be left with some level of volatility that is tied to the underlying systematic risk that affects all positively correlated assets. This remaining volatility is essentially the price you pay for participating in the market and seeking returns. Diversification is still incredibly valuable, but it is important to understand that it has its limits, especially when dealing with assets that tend to move together. You are reducing the specific risks of individual assets, but you are still exposed to the broader market risks that drive positive correlations.