

Diversification of a portfolio is measured by the correlation of the holdings in a portfolio. In a portfolio of multiple ETFs, it possible that an investor has a lower portfolio diversification than they think they do. Daily returns were used to calculate the correlations between the various ETFs in the eight simple portfolios from an Diversification of a portfolio is measured by the correlation of the holdings in a portfolio. In a portfolio of multiple ETFs, it possible that an investor has a lower portfolio diversification than they think they do. Daily returns were used to calculate the correlations between the various ETFs in the eight simple portfolios from an article by Mike Piper . These simple (lazy) portfolios give investors exposure to many assets while keeping the number of needed transactions low; free websites such as ETF Database let investors find out the specific holdings of each ETF. The ETFs in each portfolio can represent distinct asset classes, such as stocks (IVV), bonds (BND), gold (GLD), etc, but some ETF combinations may do little to add to the overall diversification of a portfolio. The correlations were calculated over a three year period ending in mid-January 2013; some of the ETFs from the original article are rather new, so several were swapped out for other similar ETFs with a longer history: VOO to IVV, VGLT to TLT, VGIT to IEF, VSS to SCZ.





Update (02/02/13): A second post covers the total returns of these eight ETF portfolios.





Correlation Plots

A few comments on reading the correlation plots:

Blue indicates a positive correlation (e.g. the daily returns of the two ETFs rise and fall together in a similar manner), Red indicates negative correlation (e.g. the returns move in opposite directions).

The more the pie chart is colored, and the stronger the color, gives an indication to the strength of the correlation.

The correlation charts are over the time period specified at the top of each chart; over shorter or longer time periods the correlations may differ.

Portfolios

Conclusion

Portfolio diversification allows investors make gains under various market conditions. Each of the portfolios above has its own advantages and disadvantages and taking into account correlations of individual ETFs in a portfolio may lead to simplified decisions in a diversification strategy. The answer to "What should you invest in?" depends on your appetite for overall portfolio risk; as the risk of investments increases so does the potential for reward over the long term even though such investments are often more volatile in the short term.



