In this article, we will share an example you can use in conversations to explain diversification risk score to clients.
Think about your soccer team again. Each player has a different role, and they all need to work together to win the game. Some players are good at defense, some are good at offense, and some are good at both. In an ideal team, the players' skills would be balanced, meaning that they would all complement each other. This is similar to how a well-diversified portfolio works.
In the investment world, the Correlation Score measures how well the different parts of your portfolio (the players) work together. If all your players (stocks or assets) are doing the same thing at the same time, it's like having a team full of goalkeepers - sure, you'll defend really well, but you might struggle to score. This would give you a high correlation score, which is risky because if something bad happens (like the market going down), all your players (stocks) might perform poorly at the same time.
On the other hand, if your players (stocks) all have different skills and don't always move in the same direction at the same time, you have a more balanced and potentially less risky team (portfolio). This would give you a low correlation score, indicating that your portfolio is well-diversified.
The Correlation Score is calculated by looking at how each player (stock or asset class) moves in relation to the others over time, particularly during "extreme" events (like a big market downturn or a soccer championship game). These movements are compared to a set of "normal" or "healthy" movements, which are like the movements you would expect from a well-balanced, well-coached soccer team. The score is adjusted based on how important each player (asset class) is, just like how a soccer coach might pay more attention to the star striker's performance than the backup goalie's.
Remember, a well-rounded team often performs better than a team that relies too much on one or two skills, and the same is true for an investment portfolio. A well-diversified portfolio, where the assets don't all move in the same direction at the same time, can be less risky and more resilient in different market conditions.