After this session, you should be able to:<\/p>\n\n\n\n
understand the concept of correlation and how it can aid portfolio construction and asset allocation<\/li>
understand the impact of diversification and rebalancing on portfolio risk and return<\/li>
use Capital<\/abbr> Asset Pricing Model concepts for performance measurement.<\/li><\/ul>\n\n<\/div>\n\t\t<\/div>\n\n
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Understanding Correlation<\/strong><\/p>\n\t\t\t
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Combining different investments can achieve more than just a simple spreading of risk.<\/li>
Appropriately selected combinations can actually reduce the level of risk without affecting the expected return.<\/li>
It is this that makes portfolio construction such a powerful investment strategy.<\/li>
The key to unlocking this strategy is an understanding of the correlation between assets<\/abbr> <\/li><\/ul>\n\n\n
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When the price of A goes up, the price of B goes down: we can say that the daily returns of A and B are negatively correlated.<\/li><\/ul>\n\n\n\n
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If we combine the two assets<\/abbr> A and B (50 per cent of our portfolio in each) we get the line AB:
instead of ups and downs across the period, the combination of the two risky assets<\/abbr> results in a nice smooth line.<\/li><\/ul><\/li>
The smoothness of the line indicates a low risk of price movements either up or down although, as the risk is reduced, so is the return relative to holding just A.<\/li><\/ul>\n\n\n\n
Investors might opt for AB if they are risk averse and give higher priority to avoiding short-term fluctuations than to seeking the highest possible return over the whole investment term.<\/li>
This would imply that investors view the systematic negative correlation of the daily returns of A and B as stronger and more likely to persist than either the overall upward trend of A or the downward trend of B.<\/li><\/ul>\n\n\n\n
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Correlation Coefficient<\/strong><\/p>\n\t\t\t
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The exact correlation is measured by the \u2018correlation coefficient\u2019, essentially an index number that records the degree to which two series of values (in this case, daily returns) vary (or not) in line with each other.<\/li>
The correlation coefficient lies between \u22121 (perfectly negative correlation) and 1 (perfectly positive correlation).<\/li><\/ul>\n\n\n\n
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