Question

Efficient diversification was discussed in Chapter 6. Diversification in an investment portfolio is a significant concept for creating the highest return for the least amount of risk. To create this diversification portfolio managers consider the correlation of investments. Thoroughly explain how correlation is interpreted and how it can help with the creation of a diversified portfolio.

Answer 1

Correlation can be defined as a measure of Change in one measurement with respect to another measurement of a similar kind. Correlation in finance or stock prices can be interpretted as the relative movement of a stock price with respect to another stock/index price/value.

For example: Let us consider two stocks with the following Daily price movements.

	Price difference between Open and Close
Day	Stock A	Stock B
1	5	7.5
2	5	7.5
3	10	15
4	-2	-3
5	-9	-13.5
6	1	1.5
7	6	9
8	-7	-10.5
9	2	3
10	5	7.5

We can see that the Price movement in Stock B is exactly 1.5 times the Price movement in Stock A. This means Correlation coefficient of Stock A & B is 1.5

How does correlation help to build a Diverse portfolio with reduced risk?

In the above example, if we consider a market scenario where the trading price of Stock A is going down then it also may affect Stock B price and make it go down. This means the portfolio will have a loss on both the stocks and risk of loss is higher than the individual cases of owning only Stock A or Stock B. But if we had Stocks with 0 correlation, meaning the historical price movements of one stock did not have any type of relationship with another stock, the loss would be only on Stock A but not on Stock B. This loss might have even be covered by a gain in Stock B. Such a portfolio has lower risk for the same level of expected profit. This way, constructing a portfolio of stocks having very low or negative correlation helps to increase the diversification of the portfolio and also the inherent risk of the portfolio as a whole.

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