Too much of a good thing could be bad for you

Too much of a good thing could be bad for you

Imagine that you bought a killer mutual fund let’s say one that invests in US red widget manufacturers – that’s on a sure but steady upwards tear. You could be tempted to buy another fund in the same sector this time blue widget manufacturers in the US – on the deluded pretence that you’re diversifying.

Let me set you straight. Buying different funds in the same sector is not diversification.

Different funds in the same sector tend to be correlated. That means they more or less go up and down together.

Given this advice, you might pick a different a different fund – yellow submarine painters in the US. You’re still, however, investing in the US. Companies in the US tend to rise and fall together (although to a lesser degree than companies in the same sector).

Ideally, you want mutual funds that are not well correlated, and to do this you need to go further afield. Check out this chart.

It list the correlations of several indices across the world.  A correlation of 100% means that that the two paired indexes go up and down in perfect lock-step. For diversification you want lower values. So if you’ve already invested in the S&P 500, you probably don’t want to invest in the S&P Midcap 400. These two indices have a correlation of 96.73%. That means if one goes up, the other probably will as well.

Instead consider investing in another sector altogether. MSCI Emerging Markets, for example, has a correlation of only 52% with the S&P 50 . If one goes down, there’s a fair chance that the other won’t.

Of course, there are other factors as well. MSCI Emerging Markets is a lot more volatile than the S&P 500, so you’ll want more in the latter than the former.

And, ultimately, if the world economy nosedives, then very few sectors of the economy are immune. Witness the wholesale destruction of value in 2008. Not even the well diversified investor was let off the relentless downward march of the stock market.