Question

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. Based on your reading, thoroughly explain how correlation is interpreted and how it can help with the creation of a diversified portfolio.

Answer 1

Diversification is the process of combining variety of assets to reduce the overall risk of the investment and achieve the greatest return possible. It can be only used to reduce the portfolio risk but not the market risk of investment because it cannot be diversified.

Correlation is interpreted as the intensity to which two variables move together. For example - Gold and inflation. Consider these two investments how they move together with time and market. If there is a 1% change in Inflation, by how much % Gold's Price will fluctuate.

Correlation can both be positive and negative. It can be 0 too. It ranges between -1 and +1.

A -1 correlation is interpreted as a change in which both variable change by same percentage but in the opposite directions.(perfectly negative relation).

A +1 correlation is interpreted as a change in which both the variables change by the same amount in same direction. (Perfectly direct relation) .

Correlation can be used in diversification as a means to reduce the risk of portfolio and to achieve highest return possible . Let me explain this with the help of an example- Let's say a portfolio consists of 40% Equity and 60% debt securities and you believe they have a very high correlation with respect to market. You expect a return of IRR 15% from this portfolio but it has a very high risk according to your risk taking ability. Now, what can be done is an asset with a low correlation with the portfolio like gold or real estate so that they dont move with the other assets in portfolio when the market moves. In this way return may be compensated but the risk of the portfolio will be reduced. This is based on the phenomena of finance called higher the risk, higher the return.

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