Question

Explain the significance of correlation coefficient and the covariance in the portfolio design strategies.How does it influence the benefits that can be derived from the diversification?

Answer 1

Covariance can be used to maximize diversification in a portfolio of assets. Covariance can only measure the directional relationship between two assets. It cannot show the strength of the relationship between assets. The correlation coefficient is a better measure of that strength. Covariance is a statistical measure of the directional relationship between two asset prices. Portfolio theory uses this statistical measurement to reduce the overall risk for a portfolio. A positive covariance means that assets generally move in the same direction. Negative covariance means assets generally move in opposite directions.

The covariance of two assets is calculated by a formula. The first step of the formula determines the average daily return for each individual asset. Then, the difference between daily return minus the average daily return is calculated for each asset, which numbers are multiplied by each other. The final step is to divide that product by the number of trading periods, minus 1. Covariance can be used to maximize diversification in a portfolio of assets. By adding assets with a negative covariance to a portfolio, the overall risk is quickly reduced. Covariance provides a statistical measurement of the risk for a mix of assets.

According to the modern portfolio theorist, investors should measure the correlation coefficients between the returns of different assets and strategically select assets that are less likely to lose value at the same time. Modern portfolio theory (MPT) emphasizes that investors can diversify away the risk of investment loss by reducing the correlation between the returns from the select securities in their portfolio. The goal is to optimize expected return against a certain level of risk. According to the modern portfolio theorist, investors should measure the correlation coefficients between the returns of different assets and strategically select assets that are less likely to lose value at the same time.

combining imperfectly correlated assets (anything with a coefficient between -1 and +1) to a traditional 60/40 strategy and expanding the opportunity set, the entire efficient frontier moves up and to the left, which means more expected return at any level of risk; a portfolio’s expected volatility may be reduced, often without a significant effect on returns. With everything else equal, the closer the coefficient is to -1, the larger the benefit of diversification will be on reducing volatility. As the theory goes, this move is a good thing for investors.

One of the most important principles of investing is to ensure that you have a diversified portfolio. This means ensuring that you spread your capital amongst different investments so that you’re not reliant upon a single investment for all of your returns. The key benefit of diversification is that it helps to minimise risk of capital loss to your investment portfolio.

Three key Benefit of diversification include:

1. Minimising risk of loss – if one investment performs poorly over a certain period, other investments may perform better over that same period, reducing the potential losses of your investment portfolio from concentrating all your capital under one type of investment.

2. Preserving capital – not all investors are in the accumulation phase of life; some who are close to retirement have goals oriented towards preservation of capital, and diversification can help protect your savings.

3. Generating returns – sometimes investments don’t always perform as expected, by diversifying you’re not merely relying upon one source for income.