The issue of correlation is critical to the level of diversification in a portfo

Question

The issue of correlation is critical to the level of diversification in a portfolio. There is a saying in the investing community that "correlation between assets increases during periods when diversification is most needed". What does the statement mean and how does this impact an investor? How can an investor overcome this using traditional asset classes? 1. Explain what is correlation and its role in a portfolio? Discuss why assets within a similar asset classes (only traditional asset classes) have high correlation with each other, while assets across asset classes will have low correlation with each other? 2. Why does correlation change during periods of sharp market decreases? [Discuss the academic literature on this as well) 3. Explain which asset class is relevant for discussion here? Both equities and Bonds? 4. Based on your answer in part 3, explain how investors can overcome this lack of diversification?

Explanation / Answer

1.Correlation is a statistical measure between two or more assets and their dependency,which is expressed between -1and +1. Correlation in a portfolio is used to diversify away the risk of investment loss by reducing the correlation between the returns from the select securities in portfolio.

assets within a similar asset class have high positive correlation since they belong to the same industry and would be probably affected similarly by events, while assets across asset classes will have low correlation with each other because they behave differently to same events and belong to diverse industries.

2)Sharp market declines are more likely to trigger stop-loss sales, than are rises to trigger buying.n financial markets . Equity markets tend to increase in value when the economic outlook is favourable, but tend to decline when the economic news is less positive.
3)Both equities and bond is relevant here as they belong to different asset class , and are inversely related. Since they are inversely related if one asset class goes down the other will go up hence diversification into two different asset class would diversify the risk of investment.Bonds react in an opposite manner, tending to decline in value during favourable economic conditions, but rising in value when the economy takes a downward turn. This is an example of inverse correlation.

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