How Does Correlation Influence Portfolio Diversification?The aim of portfolio diversification is to reduce the risk which is inherent in owning individual securities. The investment specific risk is dependent upon the degree of correlation between movements in different holdings within the portfolio. For example, if an investor has experience of banking and is, relatively speaking, an expert on banking subjects, it would make sense to be invested in that sector. However, if our private investor only held investment positions in banking companies and they were all in the same market (eg the US or UK) there would actually be very high risks associated with these investments. It is reasonable to expect most or all companies in a sector to move in the same directions, broadly in line with each other. Such an example would be called Positive Correlation. this means that the profits, fortunes and prices of companies move up and down together. They will probably be impacted by the same or similar events. However, if the fortunes and prices of companies move in different directions in reaction to the same news, they show a Negative Correlation. If many such companies can be held together, a large degree of portfolio diversification has probably been achieved. There are some companies whose values and profits show no relation whatsoever to each other. These can be described as having No Correlation.
There is a limit to how many investments need to be held to reduce risk. Many studies have shown that an ideal number is between 15 and 20 holdings. Beyond this number, portfolio diversification does not appear to reduce the risk any further. Any further risk is likely to be market risk and cannot be removed by simply adding more holdings. Astute readers may now be wondering whether it worth most pension funds holding the multiple hundreds of assets that they do... For more information about this important topic, we can recommend visiting here and here . Other related pages include:
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