AS INVESTORS FLOCK to stocks in search of heady returns, this is a good time to think about risk. Remember, nobody has a clue how stocks will perform over the short-term, so it’s best to focus on things we can control—namely investment costs, taxes, risk and our savings rate.
Short-term risk is often assessed using beta and standard deviation. I just added a section on those two volatility measures to HumbleDollar’s money guide. While researching the new section, I came across Portfolio Visualizer’s helpful matrix spelling out the correlation between major asset classes. At the site, you can also find the correlation for two or more investments of your choosing.
How do you read the numbers? Correlation coefficients range from -1 to +1. If the correlation between two investments is +1, they rise and fall in sync. If it’s zero, there’s no correlation, while a -1 correlation coefficient indicates they move in opposite directions. If you combine investments whose returns aren’t closely correlated, you should find the resulting portfolio less nerve-racking to own.
Depending on the investments you choose, the price of that smoother ride may be lower long-run returns. In other words, adding bonds to a U.S. stock portfolio can reduce volatility a lot, but it’ll also hurt returns. By contrast, adding foreign shares to a U.S. stock portfolio will reduce volatility only modestly, but it probably won’t put much, if any, dent in your long-run returns—and it could help.