The concept of diversification is tightly coupled with the notion of correlation between securities that make up portfolio. The correlation coefficient is a statistical measurement between negative one and positive one that measures the degree to which the various assets in a portfolio can be expected to perform in a similar fashion or not. A measure of -1 means that the assets within the portfolio perform perfectly oppositely: whenever one asset goes up, the other goes down. A measure of 0 means that the assets fluctuate independently, i.e. that the performance of one asset cannot be used to predict the performance of the others. A measure of 1, on the other hand, means that whenever one asset goes up, so do the others in the portfolio. To eliminate diversifiable risk completely, one needs an intra-portfolio correlation of -1, although in reality, perfectly correlated securities are very rare.
Today, most investors and professional money managers use Sharpe Ratio or Information Ratio to measure risk-adjusted returns. The Sharpe Ratio is defined as reward-to-variability ratio and is a measure of the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy. The Sharpe Ratio is used to characterize how well the return of an asset compensates the investor for the risk taken. When comparing two assets with similar expected returns against the same benchmark, the asset with the higher Sharpe Ratio gives more return for the same risk. Investors are often advised to pick investments with high Sharpe Ratios. Please, click here to view live correlation matrix for US stocks.