Understanding the Correlation Matrix in Portfolio Analyser

What does a Correlation Matrix indicate in Portfolio Analyser?

A Correlation Matrix provides insights into how closely related the returns of different assets within a portfolio are. By understanding the correlation, an investor can gauge the diversification of their holdings and thus, the associated risk.

Correlation measures the relationship between two sets of data. In portfolio management:

  • +1 indicates a perfect positive correlation: As one asset's returns go up, the other's does too.

  • 0 suggests no correlation: The assets’ returns don't necessarily move in sync.

  • -1 indicates a perfect negative correlation: As one asset's returns go up, the other's drops.

Why Diversify?

A diversified portfolio, which consists of assets with low or negative correlations, is less susceptible to significant fluctuations in value, reducing the overall risk.

The matrix gives a visual representation of how individual assets in a portfolio correlate with each other.

The numbers 1 to 6 represent the top 6 of the portfolio holdings, and the correlation values are set with different colors, as displayed in the above image.

For example, in the provided matrix:
  • Stock 1 & 1: Since it's the same stock, the correlation is perfectly positive at 1.0.
  • Stock 2 & 1: Has a low positive correlation of 0.03, indicating only a slight movement together.
  • Stock 3 & 2: Shows a negative correlation of -0.38, suggesting when one rises, the other tends to fall.
  • Stock 5 & 3: A high positive correlation of 0.9 implies they move in tandem nearly all the time.
Given these values, the portfolio in this instance is relatively well-diversified, reducing the overall risk.

A Correlation Matrix is an essential tool for investors to ascertain the diversification level of their portfolio. By identifying assets that are less correlated or even negatively correlated, investors can spread risk across various investments, potentially reducing the impact of significant market movements on the entire portfolio.

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