Modern Portfolio Theory

Portfolio risk is best managed through careful diversification

  • The portfolio  as a whole should be far more stable than it's individual investments. 
  • Diversification is a technical term mathematically based on correlation analysis.

Non-Correlation

Non-correlated assets are not the same as negatively-correlated assets. Non-correlated assets are assets driven by differing, unrelated market or economic forces. Their price movements relative to one another tend to be arbitrary. One asset may be moving up when another is moving down at a given point in time. Yet at another time, those same assets may move up or down together. Such assets are non-correlated.

Negative Correlation

Though the market cycles of many assets coincide, others do not. Negative correlation occurs when the value of two investments regularly move in opposite directions. Equities and bonds are often examples of negatively correlated sectors.  

Correlation

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 Market events influence the economy. However, the various sectors of our market  react independently.
If a portfolio is made up of investments that share market sectors, these investments and their performance, are likely to be closely correlated: rising and falling together.If a portfolio is made up of investments that do not share market sectors, these investments and their performance, are impacted in varying ways and are not correlated: they are diversified. 

Correlation Tables

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Correlation tables are displayed as a matrix of correlation coefficients exhibiting the correlation of each asset to every other asset in the portfolio. Correlation tables will enable the advisor, the fiduciary, attorney, or judge to determine if a portfolio is diversified.   

Asset Correlation and Non-Correlation

The range of possible correlation coefficients is from 1.00 to -1.00. The prices of two assets sharing a correlation of 1.00 (100% correlation) historically move in the same direction at all times (rising and falling simultaneously). At the other extreme, the prices of two assets with a coefficient of -1.00 (negative one) are also perfectly correlated, but inversely, so one is always gaining when the other is losing.