Understanding Correlation

Key point: average correlation is a commonly misused statistic because it hides the variation around it. Portfolio managers should account for the distribution and volatility of pairwise correlations when assessing diversification, stress scenarios, and risk budgeting to avoid underestimating tail co-movement.

Analysis

Key point: average correlation is a commonly misused statistic because it hides the variation around it. Portfolio managers should account for the distribution and volatility of pairwise correlations when assessing diversification, stress scenarios, and risk budgeting to avoid underestimating tail co-movement.