As a concept, diversification is easy to understand – you simply need to own a range of investments and not put all of your eggs into one basket. Though diversifying well is often not so obvious.
True diversification is about picking investments that do not react in the same way to the same situation. This essentially means that you don’t want to have investments that are strongly correlated.
If investments are strongly positively correlated, they will move in the same direction and you will either make significant profits or losses. Likewise, if investments are strongly negatively correlated and move in the opposite direction, you will never make a profit or a loss.
To assess the correlation of your investments, you need to use the formula: Covariance of (Investment 1 and Investment 2) ÷ (the standard deviation of Investment 1 x the standard deviation of investment 2).
The aim is to build a portfolio with a slightly positive correlation (just above 0).
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