With thousands of mutual funds in existence and over 100 each at a single fund family like Vanguard, Fidelity or T. Rowe Price, you can bet there’s a lot of overlap in strategies and stocks. So, how can you tell if your portfolio of funds is truly diversified? (See also, “Mutual Funds Dos & dont’s”)

Well, you could try to calculate the precise similarity of all the holdings in each fund as often as they’re reported. But you’d have to be a math whiz with a lot of time on your hands. There’s a simpler way that even the pros use. It’s called correlation.

In a nutshell, correlation tells you how similarly two funds perform on a scale of -1.00 to 1.00, or -100% to 100%. You can use any number of different time periods to do the calculation, but I’ve found that comparing two funds over three years is a good approximation.

Correlation Is Key

When two funds have a correlation of 1.00 (or 100%), it means their performance is virtually, or actually identical, so owning both won’t provide you any diversification benefit. A correlation of 0.75 would mean that the two funds’ performance was similar 75% of the time; 0.25 would indicate similar performance only 25% of the time, and so on.

For example, Vanguard Capital Opportunity (VHCOX) has a correlation of 0.90 with Growth Index (VIGRX), but only 0.40 with Health Care (VGHCX). And Vanguard Total International‘s (VGTSX) correlation with Emerging Markets Index (VEIEX) is 0.92, while its correlation with 500 Index (VFINX) is a bit lower at 0.78.

Going a little further, a correlation of zero means there is no discernible correlation. And a negative correlation would mean that when one goes up, the other goes down.

You usually won’t see negative or zero correlations unless you’re looking at different asset classes, like when you compare Vanguard Total Bond Market (VBMFX) to one of Vanguard’s stock funds. For example, Total Bond Market’s correlation with Total Stock Market (VTSMX) is -17%. On the other hand, Total Bond Market’s correlation with the bond-heavy Wellesley Income (VWINX) is 54%.

I like to look for funds that have low correlations with lots of other funds. This means they tend to march to the beat of their own drums.

I discuss correlations in my newsletter as I analyze new funds or review our model portfolio holdings. But I also report correlations for all Vanguard equity funds every year in my annual Independent Guide to the Vanguard Funds. And subscribers to my newsletter can also access my proprietary correlation tool on my website, www.adviseronline.com.

You can use these correlations to determine whether you have too many holdings that perform similarly, or confirm that a new fund you’re looking at has the potential to provide significant diversification away from your current holdings.

You can get full access to Dan Wiener’s online correlation tool by subscribing to his newsletter, The Independent Adviser for Vanguard Investors, with a risk-free, money-back guarantee. In each monthly issue, Dan gives tens of thousands of investors unbiased, in-depth information on Vanguard funds, including the best funds to buy, those you should dump, advance announcements of new funds, changes in management, secrets the fund families won’t tell you, and much more. Join today!