What is Correlation?
Correlation is a statistical measure that describes the degree to which two assets or securities move in relation to each other. Correlation is also used to determine how closely the returns of two different investments are related to each other.
A positive correlation means that the two assets move in the same direction, which means that when one asset increases in value, the other asset also tends to increase in value, and vice versa.
A negative correlation means that the two assets move in opposite directions, which means that when one asset increases in value, the other asset tends to decrease in value, and vice versa.
Investors use correlation to diversify their portfolios, as they can select assets that have low or negative correlations with each other. This can help reduce risk by spreading out investments across a range of assets that do not all move in the same direction at the same time. By doing so, investors can minimize the impact of a single investment’s poor performance on their overall portfolio.
Advantages of Investing in Negative Correlation
Investing in negatively correlated assets can help reduce risk and improve the overall performance of your portfolio. However, the correlation between assets can change over time and does not guarantee profits or protect against losses.
Investing in assets that have a negative correlation can offer several advantages, including:
- Risk Diversification: One of the primary advantages of investing in assets with negative correlation is that it can help diversify your portfolio and reduce overall risk. When one asset is down, the other asset may be up, which can help to balance out your portfolio’s performance.
- Lower Volatility: Investing in negatively correlated assets can help lower the overall volatility of your portfolio, making it less susceptible to sudden and drastic swings in value.
- Improved Risk-Return for the portfolio: By combining negatively correlated assets in a portfolio, investors can achieve a better risk-return profile. This means they can achieve higher returns for the same level of risk or lower risk for the same level of returns compared to a portfolio with only positively correlated assets.
- Opportunity for Profit: While a negative correlation is generally sought for risk diversification, it can also present opportunities for profit. If one asset is expected to perform poorly, you can hedge against the decline by investing in an asset with a negative correlation.
Keep in mind, investing in assets with negative correlation can be challenging and limit portfolio flexibility. While it can reduce risk, it may also result in lower returns and dynamic correlation can reduce the benefits of diversification. Additionally, diversifying across multiple negatively correlated assets may result in increased transaction costs and management fees.
Why does Investor Invest in Positive Correlation?
Investing in assets with positive correlation can also offer advantages, including:
- Opportunity for Higher Returns: Positive correlation means that the assets move in the same direction, which can present opportunities for higher returns if the assets perform well.
- Increased Portfolio Concentration: Investing in assets with a positive correlation can lead to a more concentrated portfolio, which may be beneficial for investors who have a high tolerance for risk and seek higher returns.
- Simplified Portfolio Management: Investing in assets with positive correlation can simplify portfolio management because investors only need to monitor a smaller number of assets and do not need to make as many adjustments to their portfolio.
However, investing in positively correlated assets can also increase risk because if one asset performs poorly, the others are likely to follow suit. Additionally, it’s important to consider the level of positive correlation. A high degree of correlation may result in a portfolio that is highly sensitive to changes in a specific market or sector.
