Methodology

Stocks

Module 6

What is a portfolio?

Non-Correlating Assets

By diversifying with different stocks in a portfolio, an investor can reduce the levels of unsystematic risk that they are exposed to. If you do not remember, unsystematic risk is the type of risk that effects an individual stock or industry only.

However, diversifying a group of stocks does not reduce systematic risk, which is the risk that effects the whole market.

Instead, in order to reduce market risk, investors can hold non-correlated assets – assets that are not correlated with each other at all.

This helps an investor by protecting them when one particular type of asset decreases in value. 

Although it is not possible to totally eliminate market risk, holding non-correlating assets, such as bonds, commodities or real estate, can help to minimise market risk.   

Non-correlating assets react differently to changes in the market. It can often be the case that when the market of one asset type goes down, another will go up or remain unchanged.

So, if an investor holds a variety of assets, it may help them to reduce their exposure to risk.

Gold & other precious metals

When it comes to investing in non-correlating assets, gold is an obvious talking point.

Gold is a unique type of investment as it traditionally performs well when the world is in financial turmoil.

In theory, owning gold (as well as other precious metals) as part of a portfolio, would help to offset some of the losses that are inevitably endured when there is a financial crisis.

For example, in 2007, if an investor owned a portfolio that consisted of both gold (50%) and the S&P 500 (50%), they would have achieved a return that was in the region of 37.08%.

This would have prepared them well for the -37% return that was delivered by the S&P 500 in 2008 (during the financial crisis).

This happens because during a financial crisis, the value of currencies decrease due to inflation. Therefore, the price of gold becomes higher in those currencies.

Real estate investments

Investing in real estate is another way to reduce risk in a portfolio.

Real estate investments tend to react differently to economic shocks as they are often based on pre-existing contracts that guarantee the level of income that an investor receives.

In addition, real estate investments tend to hold their value in a more stable way. This is likely to be the case due to the social norm of buying a home and the ways that real estate investments are valued.

Compared with a stock market index, real estate investments tend to have a correlation coefficient that is between 0.5 and 0.7. 

As stock market indices are more stable than individual stocks, this means that real estate investments can play a significant role in terms of minimising risk in a portfolio.

For example, if the S&P 500 delivered a loss of -20%, it would suggest that real estate investment should achieve a loss of between -10% and -14%.

This may not sound ideal but it would be beneficial if a portfolio included stocks that made an average loss of -50% in the same period.

That's wrong - try again!