Diversification and Covariance

The idea behind diversification is a simple one – spread your investments out to a bunch of different industries such that if a downturn hits one, you aren’t entirely exposed. That’s the simple explanation and it’s trying to distill a more complex topic that requires a bit of explanation to fully understand. This post will have no math in it, to warn you, but it will explain some ideas that sound a lot like math. 🙂

The idea behind diversification is actually designed to maximize your returns given your level of risk. When experts advise you to spread out your investments, what they’re really advising you to do is put it in investments that have a low covariance with each other but they’re saying it in plain simple language. Covariance is a statistical measure used to calculate how closely two particular investments move with one another. A high positive covariance means that when one goes up, the other goes up just as much; a high negative covariance means that when one goes up, the other goes down just as much. You don’t want either, you want two investments that have low (positive or negative) covariances.

So, when you diversify, be sure to check the covariances of your investments because if you pick the wrong ones, your diversification strategy may not help you as much as you think.