Thus you can see that gold and the Dow Jones Industrials’ returns are hardly related at all, while the Treasury Fund Index tends to move in somewhat the opposite direction of the Dow Jones Industrials.Ī matrix is helpful in that it provides precise information. The correlation matrix shows how pairs of assets are related: a value of 1 indicates that the corresponding pair of assets go up and down in perfect synchronization, a value of 0 indicates there is no relationship between their fluctuations, and a value of -1 indicates that when one goes up, the other goes down by the same amount. Let’s calculate the correlations among their returns since 2010. Specifically, I’ve chosen the Dow Jones Industrials (DJI), gold (GLD), and the US Treasury Index Fund (TUZ) as a sample portfolio. Below, I have selected three asset classes-stock, commodity, and fixed income. In order to achieve effective diversification, we need to find asset classes with return correlations that are either small or negative, indicating that their returns either don’t track each other at all or move in opposite directions. Therefore, allocating an investment between Dow Jones Industrials and S&P 500 is not a good strategy for diversification. The numerical correlation is nearly 1, an indication that their returns track each other extremely well. The similarity of the two plots above shows the highly correlated nature of S&P 500 and Dow Jones Industrials. You can download the Computable Document Format (CDF) version of this post below to execute this code yourself.Ĭumulative return shows how much an investment changes over time. The following chart shows the S&P 500 and Dow Jones Industrials indices, indicators of return that move in sync with each other. Beyond stocks, investors can consider diversification in different asset classes such as bonds, commodities, or real estate. Instead, when some assets’ values move up, others tend to move down, evening out large, portfolio-wide fluctuations and thus reducing risk.Ī simple way to explore diversification within the stock market is to invest in stocks from different sectors or different geographic regions. The asset values within a well-diversified portfolio do not move up and down in perfect synchrony. Diversification is a way for investors to reduce investment risk.
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