Week 4

Are Commodities a Good

Way to Diversify?

- Correlation and
Diversification

UTS CRICOS 00099F

Diversification - Example

Worst
1 2 3 Average Std Dev Return

Investment 1 -10% 5% 20% 5% 12.2% -10%

Diversification - Example

Worst
1 2 3 Average Std Dev Return

Investment 1 -10% 5% 20% 5% 12.2% -10%

Investment 2 25% 5% -15% 5% 16.3% -15%

Diversification - Example

Worst
1 2 3 Average Std Dev Return

Investment 1 -10% 5% 20% 5% 12.2% -10%

Investment 2 25% 5% -15% 5% 16.3% -15%

Portfolio
(50/50) 7.5% 5% 2.5% 5% 2.0% 2.5%

Investment 1 and Investment 2 are negatively correlated

This Week

What is risk diversification?

▪ Diversify risk by investing in a portfolio

▪ Role of correlation in risk diversification

▪ Are commodities a good way to diversify?

PORTFOLIO

UTS CRICOS 00099F

Portfolio

Collection of investments/assets:
35%
▪ Securities: stocks, bonds, commodities

▪ Firm assets: buildings, inventories,

patents
65%
Portfolio Returns

▪ Weighted average of the returns on the assets in the portfolio

▪ Weights are the proportion invested in each asset

Portfolio Risk
CORRELATION

UTS CRICOS 00099F

Correlation Coefficient

Statistical measure of association

▪ Tendency of two sets of data to vary
together
▪ Bound between -1 and 1
Correlation Coefficient

Positively Correlated Negatively Correlated

Correlation Coefficient

Uncorrelated
Correlation - Example
A B
DIVERSIFICATION

UTS CRICOS 00099F

Diversification

Reduction of asset-specific risk

(standard deviation) from investing in a
portfolio of assets:
▪ Diversification occurs when assets
are not perfectly correlated (i.e. 𝞺 < 1) correlation
Diversification - Example

Worst
1 2 3 Average Std Dev Return

Investment 1 -10% 5% 20% 5% 12.2% -10%

Investment 2 25% 5% -15% 5% 16.3% -15%

Portfolio
(50/50) 7.5% 5% 2.5% 5% 2.0% 2.5%

Investment 1 and Investment 2 are negatively correlated

Diversification - Example
30%

25%

20%

15%

Invstment 2 10%

5%

0%

-5%

-10%

-15%

-20%
-15% -10% -5% 0% 5% 10% 15% 20% 25%
Investment 1

Investment 1 and Investment 2 are negatively correlated

Diversification - Example

Std Dev
Correlation -1 0 1
Portfolio Std
Investment 1 12.2% Dev (50/50) 2.0% 10.3% 14.3%
Investment 2 16.3%
Diversification – Australian Share Market

σ
Unsystematic Risk

Systematic Risk
Number of Stocks
DECISION-MAKING
BIASES

UTS CRICOS 00099F

Illusory Correlation

We see an association between two

variables when they aren’t actually
associated:
▪ We tend to focus on events that come
to mind easily
▪ We look for relations that confirm our
preexisting beliefs
Illusory Correlation - Example

Technical analysts believe a “head-

and-shoulders” pattern is associated
with a future downward trend in stock
prices.
▪ Data shows there is no real
correlation
▪ Increase in trading volume
associated with this price pattern

Bender, J. C., Osler, C. L., & Simon, D. (2013). Noise trading and illusory correlations in US equity markets. Review of Finance, 17(2), 625-652.
IN-CLASS ACTIVITY

UTS CRICOS 00099F

In-class Activity

Problem: Are Commodities a Good Way to Diversify?

Criteria: Standard Deviation and Value at Risk

Alternatives: Gold, Silver, Copper, Oil, Gas, Corn, Soybeans

Data: Weekly returns for stocks in the S&P/ASX 200 (2010-2020)

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