The objective in wealth management is to create a balanced portfolio that provides attractive returns — when the market is up and when the market is down. The best way to do that is by combining assets that respond differently to market conditions or have “low correlation” to one another.
Many financial planners believe that proper diversification is achieved by adding stocks and bonds of varying asset classes. The concept is that by adding small cap stocks to a portfolio of large cap stocks, the portfolio will be more stable. Small cap and large cap stocks may not be 100% positively correlated, but they are considered to be highly correlated, which means they often track up and down in price, step-for-step.
If adding more assets helps reduce risk and provides additional diversification, then adding assets that are not highly correlated can achieve another layer of diversification. The problem is that not too many people really understand how correlation works.
The trick is to select a combination of different asset types that are not highly correlated. Asset types are different than asset classes. Many financial planners build portfolios with different asset classes but they have neglected to diversify the most important component of a portfolio, the asset types. Is your portfolio properly diversified?
When building a house, most people get it right. They visualize what they want the house to look like and then develop a blueprint. From there they go shopping for the materials needed. Unfortunately, most investors build their portfolios totally backwards. They start the process by buying products rather than building a blueprint. It is like going grocery shopping without a list; wandering aimlessly down the grocery aisles buying a little insurance, some stocks, bonds and mutual funds. They end up buying a lot of what we call “asset clutter”.
The next time you are considering an investment, decide the purpose of the investment. If you need income, don’t buy a growth stock. Many people accumulate assets like they are trophies. This maze of assets is nothing more than a giant puzzle of confusion!