Volatility vs correlation

A friend told me over chai he wanted to add a little gold to his portfolio, then talked himself out of it. Too volatile, he said. It will just make my equity book shakier.

It sounds completely reasonable. It is also backwards, and I had the numbers on my phone, so I showed him.

His equity portfolio swings about 18 percent in a typical year. Gold swings about 15, almost as much, and most people file it under "risky" for exactly that reason. But gold rarely moves in step with stocks. So I blended them. Put 15 percent gold into the book and the whole thing swings 15.7 percent, down from 18. Push it to 20 percent gold and it swings 15.0. He added a volatile asset and the portfolio got calmer.

Here is the part nobody tells you. The risk an asset brings to your portfolio is not its own volatility. It is its volatility times how tightly it moves with everything else you already hold. Portfolio risk is not the average of the parts. If you just averaged those two sleeves you would expect the 80/20 book to swing about 17.4 percent. It swings 15.0. That missing 2.4 points is diversification you got for free, and you got it only because gold does not fall on the same days equity does.

The honest version: every correlation below one bends the blend down, and the lower the correlation the bigger the bend. That bend is the closest thing to a free lunch this business offers. It is also why a calm-looking asset that moves in lockstep with your stocks adds more hidden risk than a wild one that goes its own way.

So stop asking how volatile an asset is. Ask how it behaves in the months everything else is falling. That is the number that decides your risk, and it is the one no brochure ever quotes.

Volatility is half the story. Correlation is the half that decides: