Correlation and Diversification

In This Lesson

Understanding correlation risks and true diversification.

Duration: 35 min

Overview

Understanding correlation risks and true diversification. This lesson will provide you with practical knowledge and actionable insights you can apply to your trading immediately.

By the end of this lesson, you'll have a clear understanding of the concepts and be able to apply them in real trading scenarios. Let's dive into the details.

Key Concepts

Dynamic Correlation Patterns

Correlations change over time and spike during market stress, reducing diversification benefits when most needed.

Factor-Based Diversification

True diversification comes from exposure to different risk factors, not just different securities.

Correlation vs Causation

Two assets can be uncorrelated but both driven by same underlying factor during stress.

Alternative Risk Premia

Sources of return beyond traditional buy-and-hold: momentum, mean reversion, volatility, carry.

Tail Risk Hedging

Protecting against low-probability, high-impact events that destroy correlation-based diversification.

Practical Application

Now let's put this knowledge into practice. Follow these steps to apply what you've learned:

1. Calculate rolling correlations over multiple timeframes to see how relationships change
2. Identify underlying factors driving your positions and ensure factor diversification
3. Stress-test portfolio assuming all correlations go to 1.0 during crisis scenarios
4. Allocate portion of portfolio to uncorrelated strategies (momentum, mean reversion, volatility)
5. Implement tail hedges that profit from correlation breakdown scenarios
6. Monitor correlation regimes and adjust diversification approach accordingly

Common Mistakes to Avoid

Assuming Low Historical Correlation Means Low Future Correlation

Using historical correlation data without considering that correlations spike during crises.

Over-Diversifying Into Similar Factors

Adding more positions in same risk factors thinking more holdings equals better diversification.

Time Horizon Mismatch in Diversification

Using diversification strategies designed for long-term investors in short-term trading strategies.

Key Takeaways

Historical correlations are poor predictors of future correlations during stress
True diversification requires different risk factors, not just different assets
Correlation-based diversification fails during tail events when needed most
Alternative risk premia provide diversification beyond traditional asset classes
Successful diversification must account for changing correlation regimes

Your Next Steps

Ready to continue your learning journey? Here's what to do next:

• Review this lesson's key concepts
• Complete the practical exercises
• Take notes on what you've learned
• Practice with a demo account
• Move on to the next lesson when ready