Covariance and correlation used in asset allocation
Covariance is a measure in the field of statistics that are used to determine how the one investment changes in relation to the other. If two investments are compared and it is noted that the two are up and down at the same time, then the covariance of the investments are positive. On the other hand, if the two investment moves coincidentally against each other, then the investments are said to be perfect positive (Janovsky, 2001). Conversely, if one investment moves high while the other is low, then the organization is said to be negative covariance. If one low investment coincides with the high at the same time then it is perfect negative covariance.
The correlation coefficient is used because the covariance covers a wide range of values hence affected by the outliers. Correlation compares the covariance of the negative covariance and positive covariance. It measures the degree of correlations that range from the one perfect positive correlation to one negative correlation. Therefore, the correlation coefficient is the best to use while allocating assets. This is because of the minimal deviation from the mean value.
During the resource allocation, the correlation coefficient is critical in determining the change in the stock market. Positive correlation coefficient indicates that there is optimistic dependence. This is because the correlations change over time in relations to diversity in the stock market.
Janovsky, A. E. (2001). Asset Allocation, Performance Measurement, and Downside Risk. diplom.de.