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CAUTION: Actual correlations may be larger than they appear

Akhil Lodha | December 7

Looking at historical correlations is a lot like seeing objects through a rear-view mirror—they’re behind you and they may be larger than they appear. That’s especially a problem when volatility increases.

The typical “diversified” portfolio holds a mix of stocks, bonds and, sometimes, alternatives such as real estate and commodities. But it’s probably not as diversified as you think. Especially when volatility starts to climb—correlations rapidly increase and diversification quickly disappears.

Watch your blind spot

Volatility is the investing blind spot. It’s not enough to look back at correlations. An options overlay strategy can help manage volatility as an asset class, without changing the underlying investments.

A collision course with volatility

Broadly allocated portfolios look diversified on the surface. But because each slice of the portfolio has short exposure to volatility, we need to offset this with an overlay that balances the portfolio by adding long exposure. Otherwise, the portfolio remains vulnerable, whenever volatility spikes.

To learn more about the truth behind asset correlations and volatility, click here for our complimentary eBook "The Five Myths that Put Portfolios at Risk: Revealing the truth and improving investment outcomes using options."