In portfolio construction, covariance and correlation are used to understand the relationship between different assets. Both covariance and correlation are statistical measures that quantify the relationship between two assets.
Covariance is a measure of the extent to which two assets move together. It is a scalar value that indicates the direction of the linear relationship between two assets. A positive covariance between two assets means that they tend to move in the same direction, while a negative covariance means that they tend to move in opposite directions.
Correlation, on the other hand, is a normalized measure of covariance. It is a value between -1 and 1 indicating the strength and direction of the linear relationship between two assets, but it also accounts for the individual variability of each asset. A value of 1 indicates a perfect positive correlation, meaning that the two assets move in the same direction. A value of -1 indicates a perfect negative correlation, meaning that the two assets move in opposite directions. A value of 0 indicates no linear relationship between the two assets.
When constructing a portfolio, the goal is to diversify investments across asset classes with low or negative correlation. This can reduce the overall volatility of the portfolio and increase the potential for higher returns over the long term. For example, if an investor holds stocks and bonds in her portfolio, and the returns of these asset classes are uncorrelated or negatively correlated, a decline in one asset class may be offset by a rise in another, reducing the overall risk of the portfolio.
In contrast, a portfolio that is highly correlated across all asset classes would be more vulnerable to market downturns, as all of the assets would likely decline in value at the same time.
Thus, by understanding the correlation between different assets, a portfolio manager can:
- Diversify the portfolio: A portfolio manager may seek to include assets in the portfolio that have low or negative correlations, as this can reduce the overall risk of the portfolio. By diversifying the portfolio, the portfolio manager can ensure that the portfolio is not overly exposed to any particular risk.
- Construct an efficient portfolio: By understanding the correlation between different assets, a portfolio manager can construct an efficient portfolio that maximizes expected return for a given level of risk. An efficient portfolio has the highest expected return for a given level of risk, or the lowest risk for a given level of expected return.
- Manage risk: By understanding the correlation between different assets, a portfolio manager can better manage the overall risk of the portfolio. For example, a portfolio manager may include assets with negative correlations to reduce the overall risk.
Refer to the ‘Asset class correlation assumptions‘ section in our Investment Methodology page for more information.
Related information
Refer to the related knowledge resources:
- An introduction to Modern Portfolio Theory (MPT)
- An introduction to Efficient Market Hypothesis (EMH)
- An introduction to Random Walk Hypothesis
- An introduction to reversion to the mean
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