Effect of Combining Two Securities 🤝📈
What happens when you mix different stocks together? The result depends almost entirely on the Correlation between them. In this chapter, we look at the three major scenarios of combining two securities (A and B).
Scenario 1: Perfect Positive Correlation (r = +1.0)
When two stocks move exactly in the same direction at the same time (e.g., two large oil companies).
- Risk: There is no risk reduction. The portfolio's Standard Deviation is a simple weighted average of the individual risks.
- Graph: A straight line connecting the two assets.
SDp = (Wa * Sa) + (Wb * Sb)
Scenario 2: Perfect Negative Correlation (r = -1.0)
When one stock goes up, the other goes down by the exact same amount (e.g., a Gold mine vs. a Stock market index).
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- Risk: You can eliminate risk entirely! By choosing the right weights, you can build a Zero-Risk portfolio.
Important
Finding two assets with a correlation of -1.0 is almost impossible in the real world. However, finding assets with low correlation (0.1 to 0.4) is very common and still very effective.
Scenario 3: No Correlation (r = 0.0)
When the movement of one stock has no relationship with the other (e.g., a Soap company and a Tech company).
- Risk: Risk is significantly reduced, but not to zero.
- Graph: A curve that "bows" out toward the left (lower risk).
Summary of the Effect
| Correlation (r) | Risk Reduction | Practicality |
|---|---|---|
| +1.0 | None. | Common for stocks in the same sector. |
| 0.0 | Moderate. | Common for stocks in unrelated sectors. |
| -1.0 | Maximum (Zero risk possible). | Theoretical; extremely rare. |
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Summary
- The benefit of combining assets is highest when correlation is lowest.
- Buying uncorrelated assets is like buying "insurance" for your portfolio.
- Most stock pairs have a correlation between +0.4 and +0.6, meaning there is still a good benefit to diversifying.
Quiz Time! 🎯
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