Correlation-Adjusted Risk Tool

Modern Portfolio Theory: Adding a high-volatility asset to a lower-volatility portfolio has the potential to reduce risk. 

It seems that many of today’s investors have it backward. They start with a risky portfolio, largely comprised of stocks, and try to add less-volatile assets to reduce risk—and they are often surprised when they also get less return. It would benefit them to heed Markowitz’s guidance. His objective was to lower risk and increase returns by adding higher-volatility asset classes with strong return characteristics.

How can adding a volatile asset class such as tactical Bitcoin reduce the risk of a bond portfolio? Most would think that adding tactical Bitcoin would raise the average volatility of the combined portfolio. But it doesn’t. That’s because of correlation—which measures the relationship between two investments. The lower the correlation, the greater the chance for an asset to provide diversification benefits. And if investments are going up and down at different times, some of the volatility is canceled out.

The images above illustrate the impact of adding high-returning, high-volatility assets incrementally to a portfolio. If an asset is highly correlated, there will be little or no curve in the frontier—rather, a straight line will form with each allocation, and risk is increased along the way (left image). Provided the high-volatility asset has a very low correlation, the curve will be more dramatic, initially reducing risk before it begins increasing (right image). The idea is to find an optimal point where the risk/return level matches an investor’s risk tolerance and objectives.

Not all high-volatility assets are the same. Some high-return/high volatility investments—such as international companies, emerging markets, and sectors like technology—also have periods of high correlation to domestic stocks, especially during periods of market stress. But there are some—managed futures, commodities, and Tactical Bitcoin, for instance—that have a history of maintaining a low correlation to domestic stocks, even during market stress. In fact, the more volatile and less correlating an investment is relative to a core portfolio, the less of it you have to use to receive the potential diversification benefits. When used in concert with correlation, high-volatility assets may enhance returns and lower risk in a well-diversified portfolio.