Measuring Portfolio Diversification Correlation – A Common Mistake

Take care to avoid common mistakes when Measuring Portfolio Diversification Correlation. It is especially important to not view the results with blinkers on and ignore important information that is right in front of us.

Ultimately we want to improve the robustness of our trading strategies and Measuring Portfolio Diversification Correlation is a beneficial way to do this. But it is possible to wrongly make assumptions ignoring data, often unintentionally.

The easiest way to illustrate this is in Excel. Remember in the previous video we promised you, you don’t need to have experience in coding.

Well, we keep our promises.

You’ll need to first import the data of the assets you want to compare. Next up, pick the two assets you want to measure the correlation of. Input your formulas into excel and let it figure out the rest.

Next, display your results in a nice visually easy manner and you’re almost done. A couple of clicks later and you have an easy to see chart and the (R²) number.

Using the (R²) instead of (r) removes the negative numbers and groups the positive and negative correlation together, as these both can have a negative impact.

Remember we said at the start, you need to avoid some mistakes when measuring portfolio diversification correlation.

If we pick two assets that have the same quote currency, the USD for instance, you would expect two XXXUSD pairs to be correlated but…

WARNING

They will not always be correlated due to differences in the base currency. This can give an unreliable (R²) figure. You can see on the chart in the video there are many outliers. Although we have a nice high (R²) score, you need to be careful.

If we now do the same for two stock index pairs, we can expect these to be correlated. Stock indexes tend to move together, which they are. So even though these two pairs give us similar results we can trust the stock index value more.

When systematically testing various aspects of your trading strategy you need to try to disprove your theories. Yes, disprove. Only by trying to disprove them will you find truly robust parameters and metrics to use.

Which of these 3 pairs do you think has the strongest correlation?

  1. AUDUSD & NZDUSD
  2. GBPUSD & AUDUSD
  3. AUDJPY & USDCAD

Answers on a postcard or just tag us on Twitter at @darwinexchange might be easier.

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Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

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