Question

Why is the correlation coefficient an important statistical measure for investors when they diversify their portfolio? Use an example to explain your answer.

(b) In their “Pro’s Guide to Diversification”, the US investment firm Fidelity state that “to build a diversified portfolio, you should look for assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction, and to the same degree, and, ideally, assets whose returns typically move in opposite directions.” Explain the concept of diversification. Critically evaluate the above statement. What tools should you use to build a diversified portfolio?

Answer 1

a.

Portfolio is a set of investment in different financial assets. Portfolio is risk is measured by standard deviation of portfolio return over the period. all the assets included in portfolio has their own risk. To minimize the risk the fund manager use diversification technique. Diversification is one of the way, use to minimize the level of risk in investment in assets.

In diversification process Correlation Coefficient between assets plays an important role. When we calculate our optimal risky portfolio, we use only our assets’ means and covariance’s. it means we use the assets mean return and expected level of risk of each asset in portfolio and correlation between each assets of portfolio. if correlation between assets would be minimum that is -1 then level of risk of portfolio would be minimum.

So, to construct the optimal risky portfolio the portfolio manager chooses assets whose correlation with portfolio is minimum that is minus one.

b.

The diversification process includes invetment in different type of financial assest and different type of market. Major diversifiaction process includes:

1. Purchase Different type of assets

If investor purchase one type of assets, like stock then there is chance that the investment value of zero if company is not performing well or economy will in recession. So, as per diversification strategy, he should invest in different type of assets, like bond, stock, real estate, gold. SO, that in one time if recession hit the market few assets at least provide some return like bond.

2. Purchase assets in different industry or different type of stock

if investor purchase random stock from different industry then their chance that at one time if one stock is not performing well then other stock will perform well. in diversification strategy, the investor must consider correlation between assets. if correlation between assets is minimum then overall risk of investment would be minimum.