How Correlation and Covariance Builds A Portfolio
Making profits out of a financial market is never an easy job, and while it is done, some fundamental principles such as risk are never taken lightly. One of the most prominent techniques most investors use to profit is portfolio diversification; however, how do these investors choose assets to combine into a portfolio? Well, that is where correlation and covariance come to play. These two concepts help investors manage the values of several assets in changing scenarios to present a mathematically balanced portfolio. This article will deal chiefly with correlation and covariance and their relevance in portfolio diversification, guiding the reader step by step on the finer wrenchings of this subject.
What is Portfolio Diversification?
As the word itself means, diversification of portfolios refers to spreading sub portfolios in a portfolio in order to mitigate the risk. Even if one investment or several investments turn bad, the others in a portfolio will cover some negative or lose profits. Over time, diversification improves overall return and reduces the likelihood of a return being volatile by spreading investments through asset classes, markets, and even geographic boundaries.
For example, an investor with stocks in technology, real estate, and consumer goods would be less affected by a drop in technology stocks, provided that stocks of real estate and consumer goods are doing well.
What is Correlation?
Correlation is a statistical term used to find a relationship between the two investments. Also, it indicates whether the two investments will go higher or lower in the same direction, go in the opposite direction, or they are independent of each other. The scale of correlation coefficient is from -1 to +1.
+1: Perfect Positive Correlation: Whenever one of the assets increases, the other increases too in the same proportion.
0: No Correlation: The changes in value of one asset does not affect the other asset.
-1: Perfect Negative Correlation: The two assets have contradicting movements in value. Whenever asset 1 increases in value, asset 2 decreases and vice versa.
Why is Correlation Important in Portfolio Diversification?
When implementing diversification in a portfolio, it is optimal that the assets have low or negative correlations. If all assets are near +1 in value, than indicative of being highly correlated, then they will all move together and will not be diverse. On the contrary, assets with low or negative correlation greatly reduce the risk with market changes.
For example:
Highly correlated industries have a correlation of 0.8 or more. This means that an investor who holds stocks of companies from the same sector is likely to see the stocks moving in accordance to one another. If there’s negative news in the market, and it affects one of the stocks, all the stocks in that portfolio will suffer.
Moderately correlated stocks and bonds with a correlation ranging from 0 and 0.5 will usually move somewhat independently and will help in managing risk more efficiently.
Often stock prices and the price of gold are negatively correlated which varies from -0.5 to -1. When stock prices are low, gold prices are usually high thus neutralizing the portfolio.
Different asset classes that have different correlation levels help investors manage the volatility of the portfolio while increasing the risk adjusted returns.
What Does Variance Mean?
Variance measures the extent to which the two assets vary together in terms of magnitude and direction. Unlike correlation, covariance does not have a dimensional value. It yields raw numeric value. A positive variance in means that the assets under consideration moves in the same direction and negative variance means the move in opposite direction.
Covariance can be calculated using the following formula:
Where:
X and Y are two different assets
X_i and Y_i denote individual returns
\bar{X} and \bar{Y} symbolizes average returns
n is the observed value
Why is Covariance Important in Portfolio Diversification?
Covariance helps in determining the strength of a relationship between two different types of investments. Because Covariance values don’t have any boundaries, it can be difficult to untangle them directly. As a result, investors frequently make use of correlation, which is a scaled variant of covariance ranging from -1 to +1.
It is generally accepted that portfolios built from diverse assets benefit from low or negative covariance because it indicates a degree of disassociation, collectively minimizing risk.
Incorporating Correlation and Covariance into a Portfolio for Investment Purposes
1.Identify Assets by Correlation
When constructing a portfolio, low risk can easily be achieved by attempting to include assets with low to negative correlation. Often, investor portfolios include:
Different sectors: (example technology pay versus medical services)
Different classes: (example stock versus fixed deposit)
Countries: (example US markets versus developing markets)
Optimizing Asset Distribution
Through correlation and covariance, investors can find the suitable mix of assets. A well diversified portfolio may contain:
Growth stocks (for expected higher returns) Bonds (for returning interest and increases in value) Real estate (for increasing value and diversification) Commodities (gold) (for declining market situations)
Improving Consistency of Returns
A diversified portfolio will always have non/work together assets. This means lower returns on some assets offsets higher returns on other assets significantly reducing extreme net loss.
For instance, during gold and oil crisis, people will still rely on bonds which increases their value thus stabilizing the portfolio.
Practical Example: Portfolio Diversification With Correlation and Covariance These are examples of how to make hyphenated words: investment hyphenated in two parts 21 100000’’ epithet’’ and 2 stocks.
Stock A (Technology Sector): Covers tremendous volatility, requires cash influx and can be dumped. Stock B (Consumer Goods Sector): Cares and nurtures growth for extended time, rewarding stability in return.
If these tech stocks correlate positively, they will move together. If the tech sector collapses, both stocks will fall, resulting in losses.
Investors could beat this correlation by choosing Stock A, a Tech company, and Stock C, a Gold Mining corporation. By doing so, the investment portfolio would benefit from a negative correlation of -0.5. While the tech industry suffers, the rising gold prices will help stabilize the portfolio.
Conclusion
When building a diverse investment portfolio, understanding correlation and covariances is necessary. Investors can reduce risk while increasing potential profits when assets with low correlation are chosen for investments. Liability is minimized and profits maximized using independent degrees of assistance to each asset.