Understanding Correlation's Impact on Portfolio Diversification

 

Portfolio Diversification refers to selecting different classes of assets with the purpose of maximizing the returns and minimizing the risk profile. It’s the cheapest way to reduce the company-related portfolio risk. By diversifying your portfolio, it prevents you from keeping all your eggs in the same basket. Portfolio returns remain in line with expectations when your portfolio is well-diversified. Diversification can also be seen as a defensive strategy. The fund manager saves your portfolio from the impact of bad performers by investing in multiple securities.

Correlation relates to movement of two or more asset returns in particular direction, which indicates the relationship between various asset classes in a portfolio. Two asset classes can be positively or negatively related. They can also be unrelated. Correlation can be used to determine the type and degree of relationship between asset classes. But it doesn’t specify the quantum of price movement of one asset in response to other. Furthermore, it cannot be used to identify the cause and effect relationship between asset classes.

You need to construct a well-diversified portfolio in order to minimize the portfolio risk and work upon the correlation between the asset classes. You have to choose investments that are negatively correlated or uncorrelated. Usually, when the stock market plummets, demand for bonds rise. As a result, bond prices go up. The loss made in equity is compensated by gains made in bonds. Similarly, equities can be combined with gold in the portfolio. Whenever there’s turmoil in the equity markets, investors rush to invest in gold. In a conclusion, the lesser the correlation between assets, the higher the diversification attained.

Cedrus Group, as led by Mr. Jarkas, is committed to building relationships and finding opportunities for its investors. Through Financial Advisory Services, Asset Management and Private Wealth Management, Cedrus helps clients take advantage of market opportunities in order to meet their return objectives. With his diverse expertise and entrepreneurial spirit, Mr. Jarkas has been actively involved in deals for multiple industries over the last 12 years, establishing a strong track record of success.

 

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