Getting Into Investments That Reduce Risk
Modern Portfolio Theory considers the total performance of an investor's account.
When you plan your investments, consider the shape of the whole account. Don't think
about how risky an individual stock or bond is, but about how risky it makes your
whole bundle of investments.
The risk, or fluctuation in return, of your total investment account can be derived
mathematically. It depends on two factors -- the risk of each individual investment and the correlation between the investments.
It is that second factor that many investors forget about when determining their risk. The risk of your total portfolio is not simply the average risk of all the individual securities. To gauge your risk
picture accurately, you must understand that assets don't all go up or down at the
We've already mentioned correlation. When two assets are positively
correlated, they move in the same pattern. More importantly, when they are negatively
correlated, they move in opposite patterns, as in the graph above. This "zig-zag" effect allows
you to balance your investments, so that one investment, in theory, will always
be rising when another is falling (in practice, securities don't move so neatly or predictably).
So, remember this crucial point when you are shaping your investment portfolio: the less your assets move together, the better off you will be.