Question

A mutual funds company’s newsletter says, "A well-diversified portfolio includes assets with low correlations." The newsletter includes a table of correlations between the returns on various classes of investments. For example, the correlation between municipal bonds and large-cap stocks is 0.50, and the correlation between municipal bonds and small-cap stocks is 0.21.(a) Rachel invests heavily in municipal bonds. She wants to diversify by adding an investment whose returns do not closely follow the returns on her bonds. Should she choose large-cap stocks or small-cap stocks for this purpose? Explain your answer.(b) If Rachel wants an investment that tends to increase when the return on her bonds drops, what kind of correlation should she look for?

Answer 1

Answer:

The less the correlation between two variables means the more different their output is.

A.) If Rachel wants to diversify her investment by investing on bonds that do not closely follow the returns on the bond. then she should invest in the stocks with low correlation with bonds. I.e: small cap stocks.

B.) Similarly, due to low correlation, small cap bonds will increase ( comparatively to large cap bonds) as the return on her bonds wil drop and vice versa.