Consider the following correlations Correlation between IBM

Consider the following correlations:

Correlation between IBM and Apple = -0.20

Correlation between IBM and Disney = +0.30

Correlation between Disney and Apple = -0.70

Given this data, which of the following is most preferable if an investor can only select one pair of companies?

Solution

Correlation refers to the strength of linear relationship between two variables. Correlation is denoted by r.

Significance of correlation - Lower the correlation, greater will be the benefit of diversification in the form of risk reduction.

Suppose the wealth of an investor is presently invested in a single stock. The Investor now wants to add one more stock to his portfolio. He should make his investment decision by choosing such a stock which has lowest correlation as it would result in maximum benefit of diversification i.e. Risk reduction.

The Investor should select Disney and Apple since it has the lowest correlation as compared to the other options. The Correlation between Disney and Apple would result in maximum benefit of diversification and thereby will be beneficial to the investor.