Blessed Correlation. Damned Correlation.

The concept of correlation and Daniele Bernardi’s vision. Everyone knows the concept of correlation, and everyone has surely seen a Cartesian plan where two funds are depicted growing over the long term, while in the short term are inversely related to each other as seen on the image above (on today’s post). In 2009 I took part in a Risk Management course in London organized by Paul Wilmott (who also recently attended an annual conference of mine in Venice, www.quant.it) and Nicolas Taleb, author of best sellers Fooled by Randomness, and The Black Swan. Nicolas Taleb showed me (for the first time in my life) a graph like this: The correlation is negative in this case as well, but the funds are going down (following the same principle for which they should rise in the previous image). This second image opened my eyes to how much we tend to overestimate

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Now let’s talk about Standard Deviation from a “non-standard” point of view.

The Standard Deviation is an indicator that looks at dispersed data around a position index; it is one of the few statistical indicators that are able to measure fluctuation around the mean. In finance, especially in Italy, this indicator has become increasingly used to assess the risk of a financial instrument, illustrating that the higher the standard deviation, the higher the risk the investor runs. This association is very approximative and misleading; the standard deviation is not an indicator of risk but one of uncertainty since when it’s very high, estimates on a given financial instrument are not too reliable, and when it is low, they can be considered more accurate. First introduced by Pearson, the standard deviation is nothing but the square root of the variance, see Wikipedia for the mathematical formula. The main issue with the standard deviation from a financial use point-of-view, is not so much the

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