Wednesday May 25, 2022

Veho power code. And diversification

We do not encounter the concept of correlation between individual investment instruments as often as with risk, input, or diversification. When building a portfolio, the bag is important.

The correlation and the correlate coefficient are known mainly from statistics, where it expresses the measure by which the changes of two variables are connected and ranges between 1 and +1. For investments, the correlation expresses the relationship between the return of two different investment assets.

Positive values ​​of the correlation coefficient express a positive relationship between the two quantities. The value is closer to one, the verticality is in t and vice versa. For example, when the price of oil rises, so do the tasks of processing, processing or energy companies, and so does the price of their action on the capital markets. This is an example of a positive correlation.

An example of a negative correlation (from 0 to -1) may be the situation in commodity markets with agricultural crops. As the US Department of State recently decided to sharply increase the sown area of ​​corn on other crops, its price will fall, while the price of wheat, fruit or cotton will grow. The negative correlation between bond and stock returns is also very well known.

It follows from the above that an investor who is trying to compile a diversified portfolio should take into account the correlation of the input of individual instruments, which he intends to include in it. If we focus only on performance, we can match the appropriate combination of instruments (action, fund) of the portfolio. The combination of a fund or instrument with a high correlation coefficient does not have to reduce the risk, the risk ratio and the return of the bag. On the contrary, if we combine the tools, their correlation is negative, we can achieve a much lower risk with the same input. This fact is possible from the graph, which shows two assets. One sweat with a yield of 10.7% at a volatility of 20.9% (eg shares), the second rate with a yield of 5.3% and a volatility of 9.4% (eg bonds).

Not even the use of correlation but not unlimited am my flies. Correlation coefficients for individual assets change over time and are not constant, for example due to changes in years, different economic growth, etc. Correlations are calculated from past values ​​and especially in the short term may unexpected market situation due to the fact that individual investment instruments behave full opan, we would not expect. This leads me to extraordinary gains, but thus to unexpectedly high losses.

For example, in the context of capital markets, the much-mentioned international diversification has recently made sense, because stock markets have become very upside down. The high degree of correlation between the US and Western European stock markets is not new, but recently there has been a growing relationship between developed markets and emerging economies. Recent events, when problems in the US real estate market have caused a slump in virtually all stock markets, are proof of this. The reason is also in the global collection of companies from such industries as the manufacture of automobiles, telecommunications, pharmacy, etc.

On the other hand, there are sectors of diversification, where it is possible to very effectively enforce the breeding of individual sectors at different times of the economic cycle. For example, the transport, technology or finance sectors, which are possible in times of conjunction, behave differently, and the metals or the tobacco industry, which suits the recession, behave differently.

The differences between stock and bond returns work on a similar principle, so bonds are usually listed as the most suitable tool for portfolio diversification. The mere diversification between bonds and stocks, however, does not have to be in terms of correlation. It is not always the case that when stocks fall, they issue bonds. Therefore, it is good to include in the portfolio of instruments that have a low or even negative correlation with equity instruments. Thus, a good opportunity for diversification is represented, for example, by commodities, real estate or currency (and various products derived from them and also available to conservative investors), which develop independently of the stock markets.

In the case of a wide portfolio, however, I was shown the disadvantage of using a correlated coefficient. Portfolio analysis containing stock plates, resp. investment tool is complicated (it is not necessary to assess the correlation between individual instruments, but overall for the whole portfolio). Therefore, in such cases, new methods are used, which can be simple and more accurate. Thus, the correlation is certainly not mature as large, as one of the cornerstones in the construction of the portfolio, it certainly determines the world.

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