Correlation Coefficient and Diversification

Course: Investment Planning
Lesson 13: Asset Allocation

Student Question:

In the attached concept question, wouldn’t Option (1) – a correlation coefficient of 0 – be the most diversified since there is no correlation? A correlation of -.25 would indicate a slight negative correlation.

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Instructor Response:

Good to hear from you again!  Hope all is going well.

These can always be tricky.  Don’t confuse correlation with diversification.  

If we have a 1.0 correlation, the securities will move perfectly together.  That gives us no diversification.

If we have a correlation of 0.0, there is no linear relationship.  This provides us moderate diversification since movement of one asset doesn’t give us any indication how another will move.  Totally random.  

A correlation of -1.0 means the assets would move in the complete opposite direction.  In other words, this is the maximum possible diversification.   

So given the above, a correlation of -0.25 would have more diversification than 0.0.

Does that help clarify?  Let me know any additional questions.