| Your Current Location : Asset Allocation : Correlation |
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| What is correlation? |
Correlation coefficients were introduced in finance by Harry Markowitz (1952) when developing Modern Portfolio Theory. Correlations between assets form the foundation of Modern Portfolio Theory.
When two assets covary, there exists a relationship between them. The correlation coefficient measures the strength and direction of a linear association between two assets.
Correlation between two assets is 1.0 when the prices of the two assets move completely in tandem. It is -1.0 if the price of asset A always goes up when the price of asset B goes down. Correlation is 0 if the two assets move completely independently of one another. |
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| Why is Asset Correlation Important? |
The financial concept of asset correlation is important because the goal of asset allocation is to combine assets with low correlation. The purpose of asset allocation is to lower portfolio volatility. By putting low correlation and/or negatively correlated investments in a portfolio, the overall volatility of the portfolio is lowered.
The Modern Portfolio Theory makes it is possible for an investor to create a portfolio that has a risk level that is lower than the individual risk levels of the two assets. How is it possible for an investor to create a portfolio that has a risk level lower than the individual risk levels of the two assets it contains? This is the power of diversification, which allows an investor to lower the risk level of a portfolio beyond the individual risk levels of the asset it contains. Markowitz illustrated that the variance of a portfolio’s return was a weighted average of the correlation coefficients of the returns of its component assets. Hence, to increase the diversification, investor has to reduce the portfolio weighted average correlation coefficient. |
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| What Asset Correlation doesn’t tell you? |
However, it should be noted that coefficient of correlation is one of the most widely used and one of the most widely abused statistical measures.
It is crucial to understand that correlation does not tell you anything about volatility. You can have two asset classes that are perfectly correlated, but one may be three times as volatile as the other. A commodity such as gold may be very attractive in terms of correlation but still add so much volatility to a portfolio that you will never want more than a small fractional holding in gold.
Correlation coefficient helps us in determining the degree of relationship between two or more variables but in the time of crisis, the asset returns tends to come down and correlation tends to move up among all the assets pair. This create unique problem in asset allocation and portfolio return. |
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| What is Team Genus Correlation Matrix? |
| We offer correlation matrix among asset class, counties specific indices, sector indices, bond indices and mutual fund categories. We also offer you see correlation among your portfolio constituents. You can also see the correlation drift between any fund and ETF against any index or category average over last five years. |
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