Correlations in Portfolio Theory

By Maximilian Lautenschläger, MP and Co-Founder of Iconic HoldingOne of the basic principles of portfolio theory is diversification, which aims to minimize risk — measured by standard deviation — without reducing the expected return. As can be seen in the chart below, each individual asset class has its own risk/return profile.The optimal investment would be located in the upper left corner, i.e. a high expected return with a low standard deviation. Normally, a riskier investment also provides a higher expected return.Correlations are measured with the so-called correlation coefficient, which can be anywhere between +1 (perfect positive) and -1 (perfect negative). In terms of risk diversification, both values are not desirable, since either the entire portfolio rises or falls with one event, or half of the portfolio rises while the other half falls. Diversification is mainly achieved by adding an asset that ideally shows no correlation with other asset classes. The lower the correlation between the assets in a portfolio, the more risk can be eliminated. An uncorrelated asset is considered the holy grail of portfolio construction.In the context of this article, strategic asset allocation is assumed, not tactical asset allocation. Subsequently, we are posing a question of long-term allocation into different asset classes and are not considering short-term opportunities in certain industries or the selection of outperforming asset managers.Let’s first take a look at traditional asset classes such as equities, bonds, commodities and real estate.As we can see from the upper left quadrant, equities correlate very positively with each other worldwide, so they are only suitable for risk diversification to a certain extent. Gold is very well suited for inclusion in an equity portfolio, but correlates relatively strongly with other commodities and real estate. In particular, adding bonds with a long lifetime next to stocks, commodities and real estate is…