Abstract: It’s easy to evaluate a trade-off between risk and return, but much more challenging to understand a trade-off between correlation and return, particularly as the number of securities in a portfolio increases. Investors often underestimate the significance correlation plays in portfolio performance, and underweight lower return, low correlation assets as a result. Correlation can be, and often is, more important than return.
In an ideal world, we’d be able to reduce all investment decisions to a few simple variables. Unfortunately, we do not live in an ideal world. Investing can be a difficult and confusing game. Yet the goal has long been to make it as simple as practical.
In 1952, Harry Markowitz introduced an optimization method that has become the foundation of Modern Portfolio Theory. His mean-variance model, while flawed, is nevertheless useful. It relies upon three significant inputs: measures of return, risk, and correlation. Each plays a critical role in portfolio performance, yet investors often prioritize return and risk over correlation when evaluating potential investments.