Correlation Coefficient and Diversification

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