The Importance Of Correlation

Correlation, or lack of correlation, is an important factor in portfolio construction. A portfolio constructed of two assets that have similar return and volatility characteristics, will have lower volatility than each of the individual assets if the assets returns are uncorrelated. This makes intuitive sense since as one asset moves up or down, the other asset will move up or down independently - thereby lowering overall volatility.

In fact, if each of the assets returns follow a normal distribution or Bell curve, an equal capital allocation into the assets will lower the volatility by SQRT(2). An equal allocation into N assets will lower overall portfolio volatility by the SQRT(N).

The figure below shows a plot of a data set with the monthly volatility (standard deviation) and return (mean) equal to that of the S&P 500 from 12/31/71 through 1/31/17 compared against a theoretical portfolio of 6 uncorrelated assets with volatility and return equal to that of the S&P 500. Please not that none of these data sets is the actual S&P 500 data. As expected, the volatility is reduced for the 6 asset portfolio by approximately SQRT(6) or 2.45.

 

Disclosure:

The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.

The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.

Performance data showing past performance results is no guarantee of future returns.

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