Correlation is a statistical measure that describes the relationship between two variables. In the context of portfolio diversification, correlation refers to the relationship between the returns of different assets within a portfolio. Diversification is a core principle in portfolio management, aiming to reduce overall portfolio risk by holding a variety of assets that are not perfectly correlated. The impact of correlation on portfolio diversification is significant:
Impact of Correlation on Portfolio Diversification:
Low Correlation: When assets have low or negative correlation, their returns tend to move in opposite directions. This is beneficial for diversification, as it mitigates the impact of losses in one asset by gains in another. For example, a portfolio consisting of stocks and bonds may exhibit low correlation because stocks tend to perform well during economic growth, while bonds tend to perform well during economic downturns.
High Correlation: Conversely, assets with high correlation tend to move in the same direction. This limits the benefits of diversification because losses in one asset are likely to be accompanied by losses in another. For example, two stocks in the same industry ma....
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