Portfolio analysis Essay Example | Topics and Well Written Essays - 1000 words

Portfolio analysis - Essay Example Correlation according to Cohen (2003) can be defined as the description of the degree in which two variables are related to each other. For example how is coffee business growth related to the weather patterns? Correlation can either be positive or negative meaning a single variable can affect the other positively or negatively. Covariance on the other hand can be defined as the manner two variables change at the same time. Covariance can be described as how two risky assets go hand-in-hand or in relation to one another (see C. Patrick Doncaster, 2007). If the covariance is positive this implies that the assets returns are simultaneous and if negative, this will imply the returns on the assets are inverse.Correlation and covariance both describe the relationships of two variables and in the way they move whether positively that is together or negatively that is inversely. Looking at the above definitions of covariance and correlation we can clearly see the relationship between the tw o in the context that correlation will determine the extent to which two variables are connected to each other while covariance will look at the same two variables and asses how they move together. Portfolio diversity is best achieved if the covariance is not in the same direction meaning the assets in the portfolio do not have perfect correlation (see Alexander, 2009). If the two asset variables do not have a direct relationship in terms of their asset returns this will mean that they do not move in the same direction ... Correlation as earlier defined is the relationship of various assets in a portfolio and how they impact on each other in terms of returns. In case assets have a low correlation according to Lhabitant (2004), this will mean that the assets have a minimal interaction in the market in terms of returns. If one of the assets is affected negatively this will not necessarily mean that the other assets will suffer the same adverse effects to the same degree but in a lesser degree. Negative correlation will mean that the assets have no relationship in terms of performance and this will mean that the performance of individual assets will be independent of the other assets in the same portfolio. A low or negative correlation will minimize the portfolio risk to very low levels because the assets will have no direct relation in terms of negative correlation or minimal relationship in terms of low correlation. This will mean all the assets will act as independent factors in the portfolio despite h aving a common investor. This will ensure that when one of the assets is not doing well in terms of return all the others will not be affected since they lack a relationship. A good portfolio is aimed at having the lowest risk and this can be best assessed by ensuring the portfolio mix is of assets with low or negative correlation. c. Diversification and why is it important to portfolio risk Diversification in terms of portfolio means minimizing the risk factor by investing in various assets (see Hagin, 2004). This will mean that an investor should not invest all his money in one asset but rather subdivide his money to be invested in various assets so that the risk is well distributed. Suppose an investor invests all his money in one asset this will mean that the risk