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Making Correlation an essential element of Portfolio Management

October 2016

October 03, 2016 | 12:50 | Dubai

We all understand the criticality of diversification within a portfolio. It is an essential to risk-return management. Portfolio diversification is done with the intent of lowering the volatility of a portfolio – this as not all asset categories (stocks, precious metals, bonds, etc.) may move together. Holding a variety of non-correlated assets can significantly reduce risks. This decreases the volatility of the portfolio because different assets should be rising and falling at different times; smoothing out the returns of the portfolio as a whole.

Hence, it is essential one understands the correlation between asset classes within a portfolio. Correlation is a statistic that measures the degree to which two securities/ asset classes move in relation to each other. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.

It is a general belief the Equities and Precious Metals move in opposite directions. Thus, in times of a risk-on sentiment, equities become the flavor of the day and precious metals take a backseat. Similarly, precious metals are viewed as safe haven assets and it is generally recommended to be part of the portfolio as a safety net for a rainy day. However, a back of the envelope calculation reveals that the S&P 500 (taken as a representative of Equity) and Gold have had a correlation of 0.81 for the current year, indicating the high degree of positive correlation. This simply means, Equities have risen and so has gold. This high degree of correlation could also work in the opposite manner creating a detrimental effect on the risk-return objectives of a portfolio.

Hence, it is essential one pays attention to correlation. Using past prices, a simple excel calculation can reveal critical insights which could help one setup a portfolio ensuring true diversification both amongst asset classes and within specific assets.

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