A:

Modern portfolio theory (MPT) and its precepts have widespread influence among contemporary portfolio managers. The theory states that risk among simultaneously held assets can be diversified away by reducing positive correlation among them. Managers use statistical analysis of the historical performance of various assets in an attempt to construct portfolios that have the highest potential for positive returns, as long as those returns aren't correlated too closely.

## Correlation and Diversification

Correlation is a metric used in statistics to measure the relationship between two variables. A strong positive correlation shows that two variables tend to rise and fall together at the same time. Strong negative correlations show that the two variables tend to move in opposite directions.

This simple concept is the key tool behind portfolio diversification. A diversified portfolio combines different investments to reduce overall risk by finding returns that don't correlate closely. The most common example of assets with low correlation are stocks and bonds. Even though stocks and bonds have gone through periods when they rise and fall at the same time, bonds have typically performed much better in down markets and much worse during times of high growth.

## Correlation and Investment Portfolios

Why do fund managers try to reduce positive correlation among assets in their portfolios? The assumption is that a high positive correlation coefficient indicates that both asset prices are driven by the same market forces. It would be risky to invest entirely in assets that move together at the same time; ostensibly, one single economic event could cause all of the assets to lose a lot of value simultaneously.

There are several techniques that fund managers use to estimate potential future correlation. Some use correlation matrices, which presents the correlation among several assets in tabular form. Others rely on the tools of MPT, such as beta and R-squared. Some use more complex econometric regression analysis to see both covariance and probably causation among broad indicators. The end goal is always the same: reducing correlation to reduce downside risk.

RELATED FAQS
1. ### 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 >>
2. ### 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 >>
3. ### What is the difference between positive correlation and inverse correlation?

Learn the difference between a positive correlation and a negative, or inverse, correlation and the way they apply to the ... Read Answer >>
4. ### How are negative correlations used in risk management?

Learn about risk management and how negative correlations between assets are used to diversify and hedge risk associated ... Read Answer >>
5. ### 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 >>
Related Articles
1. 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.
2. 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.
3. Investing

### How to Diversify Your Portfolio Beyond Stocks

Find out how to get diversified in asset classes beyond stocks to reduce portfolio risk. Learn how diversification can help you reach your financial goals.
4. Investing

### What's the Correlation Coefficient?

The correlation coefficient is a measure of how closely two variables move in relation to one another. If one variable goes up by a certain amount, the correlation coefficient indicates which ...
5. Investing

### Your Investments May Not Be as Diversified as You Think

Momentum trading focuses on investments that are performing well instead of passive allocation.
6. 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 ...
7. Tech

### Are Bitcoin Price And Equity Markets Returns Correlated?

Is there a correlation between bitcoin's price and the equity markets? We investigate.

### Are High-Yield Bonds a Good Bet Right Now?

Junk's popularity may be on the wane, but does that mean there's not a place for them in your portfolio?
9. Investing

### Two Great Currencies To Profit From Oil Volatility

U.S. dollar crosses with Canadian and Australian dollars offer easy access to crude oil trends due to their tight correlation with energy futures.
RELATED TERMS
1. ### Correlation Coefficient

A measure that determines the degree to which two variable's ...
2. ### Benchmark For Correlation Values

A benchmark or point of reference chosen by an investment fund ...
3. ### Cluster Analysis

An investment approach that places securities into groups based ...
4. ### Inverse Correlation

A contrary relationship between two variables such that they ...
5. ### Serial Correlation

The relationship between a given variable and itself over various ...
6. ### Correlation

In the world of finance, a statistical measure of how two securities ...
Hot Definitions
1. ### Money Market

The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
2. ### Perfect Competition

Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
3. ### Compound Interest

Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
4. ### Income Statement

A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
5. ### Leverage Ratio

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
6. ### Annuity

An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...