Negative correlation - maximising your investment return

Posted on: 25 October 2010 by Mark O'haire

Just making an investment is not enough to see a good return. Spreading your risks and getting good financial advice is also key.

Like most people, I just left my investments in the hands of my adviser and hoped all would be fine, but every year, when the valuation comes through, I still can't see how on Earth my adviser is paid so much for doing so little.

It seems I just go up and down with the market and have no real spread away from risk. Yet how do I change this?

This is what one investor recently asked me. Of course, it's worth remembering that the potential for gain always matches the potential loss; and if it's safe under the mattress, then the upside potential is just as horizontal.

What's important, though, is how best you can spread your money across different areas to reduce risk. For example, you might choose to buy shares in a company that makes ice cream, and to diversify, you may well choose a company that makes umbrellas.

In money speak they call this Negative Correlation, but it simply means that if even if something bad happens and you lose on your umbrellas, you'll still gain on the diversification into ice cream.

Most investments I see have little or no diversification and, as I said, are left to the randomness of markets. Easy come, easy go, as they say.

So, for the benefit of the readers, I called the investor quoted above to find out what her real concerns were, and she said that she had been told to invest into a property fund, a fixed interest fund (corporate bonds are effectively loans from you to companies) and some overseas and UK equities (stocks and shares). That seemed all very reasonable in mathematical terms; property and fixed interests are excellent diversifiers from equities.

Now, the following might be a bit academic but if all of the above were correlated together, they would act the same way - so it would be a bit like buying Wellington boots shares and umbrella shares. If, however, they were negatively correlated, then you would gain downside protection. It turns out that the investor hadn't been advised to buy a property fund, but to buy a form of property fund instead. This is called a Real Estate Investment Trust (REIT).

A REIT is a spread across a range of property companies, so you are effectively buying shares in them. REITs have a 62% correlation to UK equities and a 68% correlation to overseas equities, effectively showing why the investor's money was simply rising and falling with the market. (1) This is, of course, a common mistake.

Worse still, in difficult markets a REIT can fall by more than the stock it is invested into, which really is a Bad Day at the Races.

On closer inspection, the investor had also been advised to spread her corporate bond money across lots of different funds. This is virtually pointless as there aren't really an abundance of quality corporate bonds out there. Now, the idea behind this is that each fund manager buys the range of fixed interests in the market to achieve the best returns.  However, the investor who spreads across many funds will simply finish with a spread across many of the same corporate bonds. Where is the diversification in that? Again, we have a Bad Day at the Races.

A good Independent Financial Adviser, meanwhile, will spread your capital across a range of different funds and across all sectors. Furthermore those IFAs who specialise in investments will also be able to focus on who the best managers are for each area.

So for example, they will be able to tell you who is offering the best UK companies spread, the best UK fixed interest, the best overseas equities and the best property and cash spreads.

Each year as your investment grows they should also be able to reallocate your capital by taking the gains and realigning across the other assets. One last note of caution, though. Few financial advisers are actually specialised in investments so be sure to choose one who is aptly qualified and, of course, independent.

(1) Lipper

Need Expert Advice?

Peter McGahan is an Independent Financial Adviser and Managing Director of Worldwide Financial Planning. Worldwide has won 16 Financial Times awards in the last four years. Peter has also been named the top media IFA of the year by in 2009.

Peter comments regularly in major journals such as the Mail on Sunday, Irish News and Sunday Times and is a weekly columnist for FT Adviser. He has also appeared on Working Lunch and the Today programme. In addition he is an expert on international tax matters for a range of international publications.

Worldwide Financial Planning Ltd are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'

Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on understanding of current tax practices, which are subject to change. The value of shares and investments can go down as well as up.

If you have a financial query you would like Worldwide Financial Planning to respond to, call 0845 230 9876 or email [email protected]

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