Understanding Correlation and Diversification

Correlation Lesson Notes

• Correlation measures the relationship between two variables
• Standard deviation depends on the correlation between paired securities
• Diversification reduces portfolio risk by lowering correlation between assets
• Diversification is not about maximizing returns, but rather managing risk
• Diversification involves investing in different assets across varying companies, industries, and sectors

Diversification by Lowering Correlation

• Diversification seeks to avoid perfect correlation
• Perfect correlation indicates identical movements of paired assets
• Negative correlation (assets moving in opposite directions) maximizes diversification benefits
• Assets with no correlation (uncorrelated assets) mean one asset's movement has no impact on the other's
• Diversification aims to reduce portfolio risk

Negative Correlation

• Negative correlation reduces portfolio volatility, producing lower standard deviation
• The relationship between assets should reduce the portfolio's overall risk

Correlation as Linear Assocation

• Pearson correlation measures linear relationship between assets
• Spearman correlation ranks data points and measures the consistency of the relationship between data
• Kendall correlation is less susceptible to outliers than Pearson and Spearman correlations, and can be used for ordinal and not just quantitative data

Pearson Correlation

• Pearson correlation measures the linear relationship between two variables
• The formula for calculating Pearson correlation involves covariance and standard deviations of the two variables
• Covariance and standard deviation are used to determine the correlation coefficient
• The value of Pearson correlation ranges from -1 to 1
• A correlation close to 1 indicates a strong positive linear relationship (correlated assets)
• A correlation close to -1 indicates a strong negative linear relationship (assets moves in opposing directions)
• A correlation of 0 indicates no linear relationship

Spearman Correlation

• Spearman correlation examines the relationship between ranks of the data points
• Spearman's correlation coefficient measures the monotonic relationship between two variables
• It captures the relationship between assets without strictly requiring linearity

Kendall Correlation

• Determines the ratio concordant to discordant pairs of data points in a dataset
• Ranks the data points to determine correlation
• More resistant to outliers compared to Pearson and Spearman correlation

This quiz covers the concepts of correlation and diversification in finance. You'll learn how these principles affect portfolio risk and the importance of managing asset relationships. Explore the impact of negative correlation and uncorrelated assets on investment strategies.