Diversification & correlation

CFA Level I Portfolio Management
#1

Cheers guys,

I came across a question in the CFAI question bank that has been boggling my mind for days now.
Essentially, one had to pick two assets for a two asset portfolio. Given was a correlation matrix with 4 assets. Now I picked the assets with a correlation of 0… which turned out wrong. Correct was -1.
Now, according to MPT, wouldn’t one search for the least correlated assets possible? At -1, they would be strongly correlated (obviously negatively)… the Portfolio would become absolutely risk free and only earn the risk free rate… so you may as well not bother. Instead, you would want corr = 0 for a maximum of diversification.
What am I missing?

Thanks in advance!

Markus

#2

No.

You want the lowest correlation, not (necessarily) the one closest to zero.

Note that in the real world a correlation of returns of -1 will never happen; you’re lucky if you can get a sustainable correlation as low as -0.1.

#3

Ok, thanks, understood.
But…wouldn’t that (theoretically) „eat up“ all the returns since I am perfectly hedged? I may as well just buy the risk free asset then…?

#4

You decide what you want: high returns or low risk.

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