# Return, Risk, Correlation, and Diversification in 2 Equations

## Two equations that summarize the four essential components of a portfolio

In portfolio management, there are 4 important concepts or terminologies that can be described using 2 equations. There parameters are: Return, Risk, Correlation and Diversification.

Return is the expected portfolio return and is given by

where r_i is the expected return from the ith asset class, and omega_i are the asset allocation parameters, and obey

Risk is a measure of portfolio variance or volatility and is given by

Here, Sigma is the covariance matrix, which measures the degree of comovement or correlation between assets:

In this equation, the rho’s are the correlation coefficients. The diagonal terms represent the variance for each of the asset classes.

Diversification is measured by the parameter n in the summation. For example, n = 2 for a portfolio consisting of 2 asset classes, for instance stocks and bonds. Diversification helps to reduce portfolio variance or risk because in a diversified portfolio, the covariance matrix Sigma will be sparse, and this would lead to a smaller portfolio variance or risk.

## Case Study: Two asset class portfolio

For a portfolio consisting of stocks and bonds, if we assume that the correlation between stocks and bonds is negligible, then the portfolio return is given by

and the portfolio risk is given by

In summary, we’ve discussed 4 important concepts in portfolio management using two main equations: the return equation, and the risk equation. These two equations contain important information about asset allocation, portfolio diversification, and correlation between assets in a portfolio. A diversified portfolio can generally lead to lower risk, if the asset classes are uncorrelated or have negligible correlations. Another important factor that could reduce portfolio risk is time. Generally, a long time horizon is less riskier compared to a short time horizon. For example, when the time horizon is a day (day trading), the risk is very high, as day trading captures the day to day volatility of the market. This can generally lead to a zero sum game (gains equal losses over time). However, when the time horizon is long (long term investment), the risk is low, as time is needed to separate the signal from the noise.

## Personal Finance Analytics

Providing tips to help people learn about money, avoid debt, and invest using data-driven strategies

Written by

## Benjamin Obi Tayo Ph.D.

Physicist, Data Science Educator, Writer. Interests: Data Science, Machine Learning, AI, Python & R, Personal Finance Analytics, Materials Sciences, Biophysics

## Personal Finance Analytics

Providing useful tips to help individuals and families to be smart about money, avoid debt, and invest using data-driven strategies

Written by

## Benjamin Obi Tayo Ph.D.

Physicist, Data Science Educator, Writer. Interests: Data Science, Machine Learning, AI, Python & R, Personal Finance Analytics, Materials Sciences, Biophysics ## Personal Finance Analytics

Providing useful tips to help individuals and families to be smart about money, avoid debt, and invest using data-driven strategies

## More From Medium

Medium is an open platform where 170 million readers come to find insightful and dynamic thinking. Here, expert and undiscovered voices alike dive into the heart of any topic and bring new ideas to the surface. Learn more

Follow the writers, publications, and topics that matter to you, and you’ll see them on your homepage and in your inbox. Explore

If you have a story to tell, knowledge to share, or a perspective to offer — welcome home. It’s easy and free to post your thinking on any topic. Write on Medium