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Correlation vs. Trends: A Common Misinterpretation

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. This paper 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.

Author(s) :

François-Serge Lhabitant

Summary :

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. This paper 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.

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Type : Working paper
Date : 04/04/2011
Keywords :

Portfolio Management