Correlation and diversification, are most misunderstood terms in the filed of finance. People diversify portfolio in order to reduce downside risk; but most of them ignore the correlation (of the assets).
For
some reason, people think that diversification is owing 50 or odd stocks (i.e. holding large quantity of stocks) or variety of assets to balance and
reduce portfolio risk.
But "this is misconception."
Please note that Diversification can be achieved just by "holding few stocks/assets", but the condition is to hold those stocks "which are not correlated or less correlated."
Lets look at the the definition(s) for both the terms to clarify further:
Correlation
In finance “Correlation and dependence are any of a
broad class of statistical relationships between two or more random variables
or observed data values.” - From Wikipedia
“In the world of finance, a statistical measure of how
two securities move in relation to each other.” – From Investopedia
Diversification
In finance "Diversification is a risk management technique
that mixes a wide variety of investments within a portfolio. It is the
spreading out of investments to reduce risks" - From Wikipedia
“A risk management technique that mixes a wide variety of
investments within a portfolio. The rationale behind this technique contends
that a portfolio of different kinds of investments will, on average, yield
higher returns and pose a lower risk than any individual investment found
within the portfolio.” – From Investopedia
Hope the above definitions are clear and the concept is even more clearer.
Below table, shows the Long Term and Short Term Correlation for various asset class. I hope, this will help you to take right diversification and investment decision(s).
Happy Investing !!!
table adopted from: ING - Global
Perspectives March 2010
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