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After analyzing historical data you determine that in the past the returns on two different assets...

After analyzing historical data you determine that in the past the returns on two different assets had a correlation of 0.2. You decide to buy both assets, investing 50% of your savings in each. However, over the following year that you are holding the assets the correlation between them is much higher than it has been in the past, with correlation equal to 0.8. Explain how the performance of your account would differ from what you were expecting when you bought the assets and believed their correlation would be 0.2.

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Answer #1

Lower the correlation more is the benefits of diversification and lower is the risk. When correlation was 0.2 the risk or volatility of the portfolio was less
However when correlation increases to 0.8 the volatility or risk in the portfolio increases for same expected return. Correlation does not change the expected return of portfolio but changes the standard deviation of portfolio. Hence now the risk has increased.


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