RiskMetrics - RiskImpact of uncorrelated investments
RiskImpact of uncorrelated investments
Look for low correlations
Professional investment managers often search for new investments with low correlations to maximize diversification benefit. Ideally, we'd find completely uncorrelated assets to minimize risk. It is difficult, however, to find investments that are totally immune to common economic factors, such as inflation and interest rates.
In our sample portfolio, which consists largely of US high tech stocks, we might diversify across different industries, countries, or other asset classes such as bonds. To illustrate, let's add a foreign investment, British Aerospace (BA.).
British Aerospace's diversification effect is obvious. Although the $10,000 Market Value of BA. is 20% of the portfolio's total value, its RiskImpact is only 5%. Furthermore, even though BA.'s RiskGrade is higher than GE's, its RiskImpact is only half GE's.
We can attribute the relatively small RiskImpact of British Aerospace to its low correlation to the rest of the portfolio. Makes sense, considering it's the only non-US investment in the portfolio.