Correlation is key to diversification, but what does it mean?
We are often told that correlation is a key aspect of diversification, but what does it mean? This article explains what correlation is and provides an example of a table that could appear on the CII R02 exam – also useful for CII J10, AF4, R06 and AF5 revision.
This article is correct as at 3 October 2023.
What is correlation?
Correlation is a measure of dependency between asset classes or investments. Correlation varies between plus 1 and minus 1. If assets are positively correlated, then their returns move in the same direction (either up or down). When assets have negative correlation, their returns move in opposite directions. No correlation means there is no dependency, so each investment very much does its own thing.
The most effective diversification comes from investments that are negatively correlated. Perfectly negatively correlated assets move in the opposite direction from each other by the same amount. These would provide 100% diversification, as there would be no variance and therefore, no risk. However, it would be very difficult to find investments that work like this. An example of negative correlation would be airline stocks and oil prices for obvious reasons however airline stocks are influenced by other key factors such as demand so there will never be perfect negative correlation.
Some stocks or assets have little or no correlation i.e. the movement of two investments’ prices are totally unrelated, i.e., they are independent of each other so having a few investments with near on zero correlation would also provide good diversification.Correlation is a measure of dependency between asset classes or investments. Click To Tweet
A Typical CII R02 Exam Question
Here is a typical question from the R02 exam. You could get a table very much like this one and then need to analyse the information in order to answer the question.
Miles has the following investments correlated as shown
If investment B rises by 4%, it is most likely that investment C will
- rise by 4%.
- rise by 3.2%.
- fall by 0.2%.
- fall by 4%.
The correlation rate between Investment B and C is shown as 0.8. As the correlation is positive, as investment B rises, so will investment C. If investment B rises by 4%, investment C will rise by 80% of 4% i.e., 3.2%. So the answer is B.
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