A:

Modern portfolio theory (MPT) emphasizes that investors can diversify away the risk of investment loss by reducing the correlation between the returns from the select securities in their portfolio. The goal is to optimize expected return against a certain level of risk. According to the modern portfolio theorist, investors should measure the correlation coefficients between the returns of different assets and strategically select assets that are less likely to lose value at the same time.

Study of Correlation in Modern Portfolio Theory

MPT looks for correlation between expected returns and expected volatility of different investments. This expected risk-reward relationship was titled "the efficient frontier" by Chicago-school economist Harry Markowitz. The efficient frontier is the optimal correlation between risk and return in MPT.

Correlation is measured on a scale of -1.0 to +1.0. If two assets have an expected return correlation of 1.0, that means that they are perfectly correlated. When one gains 5%, the other gains 5%; when one drops 10%, so does the other. A perfectly negative correlation (-1.0) implies that one asset's gain is proportionally matched by the other asset's loss. A zero correlation has no predictive relationship. MPT stresses that investors should look for a consistently uncorrelated (near zero) pool of assets to limit risk.

Criticisms of Modern Portfolio Theory's Use of Correlation

One of the major critiques of Markowitz's initial MPT was the assumption that the correlation between assets are fixed and predictable. The systematic relationships between different assets doesn't remain constant in the real world, which means that MPT becomes less and less useful during times of uncertainty – exactly when investors need the most protection from volatility.

Others assert that the variables used to measure correlation coefficients are themselves faulty, and that the actual risk level of an asset can be mispriced. Expected values are really mathematical expressions about the implied covariance of future returns and not actually historical measurements of real return.

RELATED FAQS
  1. How do investment advisors calculate how much diversification their portfolios need?

    Learn how modern portfolio theory (MPT) can help determine a diversified mix of assets for inclusion in a portfolio that ... Read Answer >>
  2. What does it mean if the correlation coefficient is positive, negative, or zero?

    When a coefficient is greater than zero, it is a positive relationship; when the value is less than zero, it is a negative ... Read Answer >>
  3. How do I calculate correlation between market indicators and specific stocks?

    Discover how to calculate the correlation coefficient between market indicators and stock prices, a critical skill in technical ... Read Answer >>
  4. How does correlation affect the stock market?

    Learn about the role correlation plays in prudent stock market investing, and how the correlation coefficient is used to ... Read Answer >>
  5. How can you calculate correlation using Excel?

    Find out how to calculate the Pearson correlation coefficient between two data arrays in Microsoft Excel through the CORREL ... Read Answer >>
  6. What does a negative correlation coefficient mean?

    Discover the meaning of a negative correlation coefficient, how this compares to other correlation coefficients and examples ... Read Answer >>
Related Articles
  1. Managing Wealth

    Manage Investments And Modern Portfolio Theory

    Modern Portfolio Theory suggests a static allocation which could be detrimental in declining markets, making it necessary for continuous risk assessment. Downside risk protection may not be the ...
  2. Insights

    Prices of Stocks and Bonds Move More in Tandem

    Correlation between stock and bond prices in the U.S. have reached a 10-year high, reversing a broader trend of negative correlation.
  3. Investing

    Protecting Portfolios Using Correlation Diversification

    Understanding correlation and uncorrelated assets can help protect against random events in the market for investors. Keep your portfolio safe today.
  4. Investing

    How To Trade Currency And Commodity Correlations

    Relationships between currencies and commodities exist throughout the financial markets. Find out how to trade these trends.
  5. Trading

    Using Currency Correlations To Your Advantage

    Knowing the relationships between pairs can help control risk exposure and maximize profits.
  6. Financial Advisor

    Example of Applying Modern Portfolio Theory (MPS)

    Modern Portfolio Theory: brush up on key mathematical framework used in investment portfolio construction.
  7. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  8. Investing

    Tales From The Trenches: Perfectly Negative Profitability

    Use correlations to profit when two specific instruments move in opposite directions.
  9. Managing Wealth

    Does International Investing Really Offer Diversification?

    Historically, international investing has worked out well for investors, but this may no longer be the case.
RELATED TERMS
  1. Positive Correlation

    Positive correlation is a relationship between two variables ...
  2. Negative Correlation

    A perfect negative correlation is a relationship between two ...
  3. Pairs Trade

    A pairs trade is a trading strategy that involves matching a ...
  4. Intermarket Analysis

    Intermarket analysis looks at related asset classes or financial ...
  5. Inverse Correlation

    An inverse correlation, also known as negative correlation, is ...
  6. Spurious Correlation

    A spurious correlation is a relationship between two variables ...
Trading Center