Correlation Coefficients Hold the Key to Diversification
The correlation coefficient is a metric that expresses the co-movement of two assets on a scale from -1 to +1. A value of +1 means the assets move in exactly the same direction, -1 means they move in exactly opposite directions, and 0 means there is no relationship between their movements. To effectively reduce portfolio risk, it is important to combine assets with low - ideally negative - correlations.
Consider a concrete example. If you combine equities with an expected return of 7% and risk of 20% with bonds with an expected return of 3% and risk of 5% in a 60:40 ratio, and the correlation coefficient is +0.3, the overall portfolio risk comes to about 12.8%. This is lower than the simple weighted average of 14% - that is the diversification effect. If the correlation is -0.3, the risk drops further to about 10.5%. Even with the same asset allocation, the degree of correlation dramatically affects risk reduction.
Understanding Correlations Among Major Asset Classes
Over the past 20 years of data, the correlation between Japanese equities and developed-market equities is about 0.7 - quite high - so the diversification benefit is limited. On the other hand, the correlation between equities and domestic bonds is roughly -0.1 to 0.2, meaning combining them can effectively reduce risk. Gold and equities have a correlation of about 0.0 to 0.2, and during crises it often turns negative, making gold an effective portfolio stabilizer.
An important caveat is that correlation coefficients are not fixed values - they fluctuate over time. Books on asset allocation in practice explain in detail that during financial crises like the Lehman shock, assets that are normally low-correlated can all plunge simultaneously, causing correlations to spike (correlation convergence). If you base your risk management solely on normal-period correlations, you may suffer larger-than-expected losses during a crisis.
A Practical Guide to Building a Diversified Portfolio
To build an effective diversified portfolio, start by organizing the expected returns, risks, and correlation matrix of the investable asset classes (domestic equities, developed-market equities, emerging-market equities, domestic bonds, developed-market bonds, REITs, and gold). Then find the asset allocation that minimizes risk for a given target return (a point on the efficient frontier). While it is difficult for individual investors to perform rigorous optimization calculations, low-cost balanced funds provide easy access to professionally designed diversified portfolios.
The diversification benefit increases as you add more asset classes, but beyond 8-10 the marginal benefit diminishes. Books on risk management and asset management introduce simplified approaches to asset allocation for individual investors.
Concrete Actions to Start Diversified Investing
The starting point for practicing diversified investing is to understand your own risk tolerance. Evaluate your age, income stability, investment horizon, and psychological tolerance for losses comprehensively, and decide on a basic ratio of equities to bonds. A common rule of thumb is "100 minus your age equals your equity allocation (%)": at age 30, that means 70% equities and 30% bonds; at age 50, 50/50.
The easiest way to start diversified investing is to dollar-cost average into a single global equity index fund through a NISA (Nippon Individual Savings Account). A global equity fund provides diversification across roughly 50 countries and thousands of stocks in a single product, eliminating the need to calculate correlations yourself. If you want to further reduce risk, combining it with 20-40% in a domestic bond fund can significantly dampen overall portfolio volatility. Start with as little as 10,000 yen per month, and increase the amount as you become more comfortable with investing - that is the most realistic step.