The benefit of diversifying your portfolio is to manage your risk. No one wants to lose all of their investments from not knowing how to diversify their portfolio. The older you get the more important it is to ensure you reduce your risk in your portfolio.
Asset classes refer to the different types of assets that you can put into your portfolio. There are 14 asset classes and they are all listed below.
Each of these asset classes has a correlation with each other. A comprehensive list of how each asset class correlates with another is located here. While the chart may seem overwhelming at first, it is actually quite simple. You look up an asset class along the vertical axis and an asset class along the horizontal axis. The box in which the two asset classes meets inside the chart is the number representing the correlation between the two asset classes.
Within each asset class there will be a wide range of sectors. You can use knowledge of sectors within the asset classes to further diversify your portfolio.
Each number in a box represents something very important; the correlation between the two asset classes. Correlations can range from -1 to 1, with 1 being perfectly correlated and -1 being oppositely correlated. You will find the boxes where an asset class meets the same asset are all 1s. This shows that the two asset classes that are the same are perfectly correlated. As you get closer to 0 and further into the negatives your two asset classes become less correlated.
The purpose of these numbers is to show you how related two asset classes are. The less related the asset classes are, the more you are diversifying your money. Let’s use two asset classes and see how they compare. I’m going to choose U.S. Large Cap Value Stocks (My Favorite) and U.S. Investment Grade Bonds. U.S. Investment Grade Bonds are bonds that are rated BBB and above and are owned by either the U.S. Government or very large corporations.
I find U.S. Large Cap Value Stocks on the horizontal axis and U.S. Investment Grade Bonds on the vertical axis and I see that they have a correlation of .230. This is a very low correlation and means that I will be diversifying my portfolio by buying the bonds when I already have the stocks or purchasing the stocks when I already own the bonds.
You can now do this on your own you will be able to decide whether or not you are diversifying your portfolio or actually adding more eggs to the same basket. The more diversely correlated you can make your portfolio the less risk your portfolio has when there is a major movement.