Computer Exercise #4 - Correlation - 03-02-2011

# Computer Exercise #4 - Correlation - 03-02-2011 - EE 0822...

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EE 0822 INVE\$TING FOR THE FUTURE MR. LENGKEEK INVESTING TOOLS 4. CORRELATION? NEVER HEARD OF IT! What is correlation? Correlation is a method used to see how two sets of data (in the simplest of cases) are linked or related to each other. For example, if we plotted the level of light during a cloudless day against temperature we would expect that as the amount of light increased the temperature would also increase. And, if it so happens that some clouds come by, then the level of light will decrease and therefore the temperature will also decrease. So, we can say that light and temperature are correlated. What does light and temperature and their correlation have to do with investing? Correlation allows you to see how one stock’s movement is related ( correlated – can you see how related is the root of correlation?) to another stock’s movement, or to the movement of the market – like the S&P 500. What is important about correlation with regard to investing? Is correlation important for portfolio building, i.e., selecting stocks or mutual funds? The answer is a definite yes! You want to have a portfolio that is composed of investments, which, in an ideal case, would be negatively correlated with one another. Practically speaking, in most cases stocks should be at least slightly negatively correlated or at least slightly positively correlated with each other. So, you should be asking, “How can I use correlation to help me build a good investment portfolio?” The answer has to do with what is called Modern Portfolio Theory (MPT), which was introduced by Harry Max Markowitz in a paper in Journal of Finance titled “Portfolio Selection” in 1952. Dr. Markowitz won the Nobel Prize in 1990 for his pioneering work in the theory of financial economics (as related to modern portfolio theory, studying the effects of asset risk, correlation and diversification on expected investment portfolio returns). A Markowitz Efficient Portfolio is one which proposes how “rational” investors will use diversification to optimize their portfolios. The basic concepts of the theory are diversification (asset allocation), asset pricing model, and the alpha and beta coefficients (terms we will learn about later). MPT models an asset's return as a random variable, and models a portfolio as a weighted combination of assets. The return of a portfolio is thus the weighted combination of the assets' returns. Moreover, a portfolio's return is a random series of events, and consequently has an expected value 1

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EE 0822 INVE\$TING FOR THE FUTURE MR. LENGKEEK INVESTING TOOLS (mean) and a variance (and standard deviation). Risk, in this model, is the standard deviation of the portfolio's return. Let’s revisit the important statistical parameters – variance and standard deviation. Note how the terms variance and standard deviation have embedded in them what they represent, e.g., the random series of events “varies” over a wide range of values can be called the “varyance” (the correct spelling is
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## This note was uploaded on 04/19/2011 for the course EE 0822 taught by Professor Lengkeek during the Spring '11 term at Temple.

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Computer Exercise #4 - Correlation - 03-02-2011 - EE 0822...

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