Correlation vs. Trends in Portfolio Management:
A Common Misinterpretation

Abstract

Two common beliefs in finance are that i) a high positive correlation signals assets moving in the same direction while a high negative correlation signals assets moving in opposite directions; and ii) the mantra for diversification is to hold assets that are not highly correlated. The author explains why both beliefs are not only factually incorrect, but can actually result in large losses in what are perceived to be well-diversified portfolios.

TOPICS: Portfolio construction, statistical methods, risk management