Question

How can an investor use asset allocation to influence both the investment rate of return and the standard deviation of his/her investment portfolio?

How can investment correlation be used to reduce investment volatility while increasing invest return? Provide a simple example to illustrate your answer.

Answer 1

Asset allocation is key in wealth management. An investor can benefit from low correlation between different asset classes - equity, fixed income, real estate and commodities. Diversification across asset classes help in reducing standard deviation of an investor's investment portfolio and also help in generating higher returns with lower amount of risk.

Low correlation between assets can reduce the volatility of a portfoliio due to the benefit of diversification. Lower the correlation between assets, lower the volatility of the portfolio.

For example, you have a portfolio of two stocks L and M. You invest 70% in L and 30% in M. Your annual returns are as follows.

Year	L	M	Portfolio
2015	16%	22%	17.80%
2016	17%	21%	18.20%
2017	19%	20%	19.30%
2018	20%	19%	19.70%
2019	21%	18%	20.10%
2020	23%	17%	21.20%
Returns	19.33%	19.50%	19.38%
S.D.	2.58%	1.87%	1.25%

You can observe that while expected returns of L are increasing every year that of M are declining. Your portfolio which has both stocks have lower standard deviation (volatility) than that of individual stocks due to negative correlation between L and M.