Maximising opportunities: the importance of correlation and diversification

Economist Harry Markowitz is credited with coining the phrase “diversification is the only free lunch in investing”. What this really means is that by combining asset classes and strategies with a positive expectedreturn, but which zig and zag at different times, we can reduce the overall volatility of the journey and improve the risk-adjusted returns.

Correlation is a measure of the strength of relationship between different variables so it follows that if a portfolio is to be diversified it needs to contain securities with a low correlation to each other. Yet correlations do not always behave as expected, meaning investors need to have a broader consideration of what might impact them.