In this article, we will look at exactly how correlation affect the diversification services of a portfolio. Let’s take it a portfolio through two assets. The correlation in between the two assets can selection from -1.0 to 1.0 and depending on the correlation figure the shape of the efficient frontier will change.
The following graph shows how the reliable frontier will look based upon different worths of correlation. As soon as the correlation in between the heritage is 1, it method that any change in one asset is same reflected in the adjust in the various other asset. So, if one legacy goes down 10%, the various other asset will also go down 10%. Over there is no diversification benefit. In together a case any type of portfolio derived from a mix of A and also B will fall on the right line, mirroring the risk simply weighted with both assets.
However, together the correlation beginning reducing, the investment portfolio starts gaining diversification benefit and also the reliable frontier start bending in the direction of the left. The lesser the correlation between the 2 assets, the more the diversification advantage and an ext it will bend in the direction of the left. By this logic, when the 2 assets room perfectly negative correlated, that is, the correlation between them is -1, the diversification should yield maximum risk reduction. So, there could be a mix of A and B wherein the risk reduces come 0. That suggest is represented as O in the above chart. That is not yet really feasible to find assets that space perfectly negative correlated. Thus the effective frontier will generally be a curved line bending in the direction of the left, signifying some levels that diversification.
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