while explaining in class sir said that correlation among asset class should be low and in in an asset class it should be high,however sir also said that stock with low correlation should be taken in a portfolio,isint both the opinions contradicting each other?,which one is correct?
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The correlation between the assets say for example stocks should be low, because lower the correlation higher the benefit of diversification.
REASON:
Say for example we have portfolio with stock A and stock B, there are three possible cases in terms of correlation and their benefit in diversification,
Case 1: Correlation = +1, here we have zero benefit of diversification because stock A and B are moving in same direction which means that if we observe loss in stock A then because of perfect positive correlation we will also see same level of loss in stock B which means it’s useless to create portfolio of that kind.
Case 2: Correlation = -1, which means both stocks will move in opposite direction which means if stock A has loss there is same level of profit in stock B because of it’s negative correlation that too perfectly negative that means 20 rs loss from Stock A will result in 20rs profit in stock B.
But in real life it’s evident that we cannot see perfect negative or positve correlation between the assets, but +1 correlation is very dangerous and irrelevant. so we say that the correlation should lower for obtaining benifit of diversification because at the end the motive behind creating portfolio is risk reduction by multiple assets in our portfolio but wishing the correlation to be as low as possible to get benifits.
I hope I was able to clear your confusion regarding Modern Portfolio Theory.
my question was in portfolio we have asset classes,so sir explained that correlation among asset classes should be low and correlation of assets within one asset class should be high,but sir also said in some lectures that we should selesct stocks with low correlation but that would mean that correlation amongst securities in an asset class would be low…so thats my confusion…i mean how can you do both together