Question

Describe how the correlation coefficient is the key factor in determining the degree of diversification benefit.

Answer 1

The correlation coefficient is computed by comparing the movement of different assets. It helps in finding the relationship between two variables are based on their movements.

Why correlation is key factor in determining the degree of diversification benefit:

• Diversification benefit is maximum when the asset classes share low correlations.
• Diversification is achieved when stocks have low correlation with current portfolio. The low correlation ensures the stock or asset added in portfolio has different risk profile hence, the benefit of diversification is achieved.
• Asset with low correlation with current portfolio will achieve real diversification hence, diversification reduces the risk of the portfolio for an investor.

We can take more understanding on correlation coefficient from below:

Correlation coefficient is numerical value in a range of +1 to -1.

Variables share different relationship based on value of correlation:

• Correlation close to ‘+1’ indicates strong positive relationship between the asset class or variables. This means the independent variables move in same direction in most of scenarios taken in the consideration. Low diversification benefit.

• Correlation close to ‘0’ indicates no relationship between the asset class or variable. This means the independent variables move in random directions in most of the scenarios taken into consideration. Diversification is achieved since the relationship is random and correlation is low i.e. not positively related.

• Correlation close to ‘-1’ indicates strong negative relationship between the asset class or variable. This means the independent variables move in opposite direction in most of scenarios taken in the consideration. Its diversified but income of one security is negated by other security here since it is strong negative correlation.