All of us would like to live in a climate that is not too cold or hot. Similarly, we prefer to live a life that is not so hard yet not so easy. Being at both ends of the spectrum of business and life is not pleasant for everyone. So, we plan our life accordingly, and businessmen strategize their trades that fit every economic and climatic condition. For example, my uncle converts his shop into an ice cream or juice parlor in summer and trades blazers in winter.

Like my uncle, I, too, had opted for dual specialization: A major in Finance and a minor in Marketing. I thought specialization in two fields would reduce the risk of not getting any job. Finally, I got a job in marketing financial products, which suited me well for a dual specialized postgraduate.

Today, I ventured into long-term wealth creation by investing in asset classes like equity, debt, gold, alternative investments, realty, etc., for better diversification. Keep in mind that we can do intra-diversification within each asset class. For instance, there is a spread between commercial, residential, and plot in realty. In equity, there is a spread between Indian and US equity. There are also spreads in equity between small, mid, and large capitalization categories.

I believe that returns are made in specific investments, but wealth is preserved in diversification. And I focus more on wealth preservation rather than minting higher returns. I also believe that investing in non-correlated asset classes can mitigate the risk. Therefore, my investment objective is to achieve positive inflation-adjusted return through investing in non-correlated asset classes.

What does correlation mean?

In investment, correlation is the measurement of the degree to which prices of two securities or asset classes move in relation to each other. The correlation coefficient is the measurement scale of correlation. For example, +1 is the perfect positive correlation coefficient, implying that prices of two stocks or asset classes move (up or down) in the same direction. In the case of a negative correlation coefficient denoted by -1, the price of two securities or asset classes moves in the opposite direction. A zero correlation coefficient means no linear relationship between two variables.

The examples of these three correlation coefficient scenarios are given below.

1. Large-cap mutual funds generally correlate positively to the Standard and Poor’s 500 (S&P 500) Index.
2. US Dollar has zero correlation with Indian equity.
3. Gold and Indian equities often move in opposite directions. So, they are negatively correlated.

So, although we can achieve diversification by investing in various asset classes, how they correlate is also significant. This is because adding a negatively correlated asset class in a portfolio can considerably reduce the risk without compromising the expected return rate.

While creating a diversified yet non-correlated portfolio, we must put the effort in the right direction by knowing that correlation can change per various market conditions.

We also need to keep in mind these five points about non-correlated assets.

1. The perfect identification of negatively correlated asset classes is nearly impossible. For example, although gold and Indian equity are negatively correlated, there are times when their prices move in the same direction.
2. Portfolios with non-correlated assets are not guaranteed to give you high returns. More than enhancing returns, they reduce the investment risk without cutting it completely. Still, investments are prone to various risks.
3. More than being non-correlated is needed for investing. It is also vital that asset classes should be growth-oriented, which gives positive returns in the long term. For example, cash has zero correlation with equity, and keeping the former in a portfolio is not advisable.
4. If an investor chases non-correlated investments, they may end up in riskier investment avenues like crypto assets.
5. Regular portfolio monitoring and rebalancing should be done.

There are no extreme levels in a non-correlated portfolio. That means there wouldn’t be extreme gains or losses, which can lead to more consistent returns. This is because gains in an investment give a cushion to the loss in another investment. Therefore, while creating a non-correlated portfolio, your advisor needs to gauge your risk tolerance, understand your long-term financial goals and develop diversification strategies accordingly.

Happy investing!

Akhil Bhardwaj

Partner