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the role of correlation in portfolio stock diversificatio. if they are negatively correlated how does it...

the role of correlation in portfolio stock diversificatio. if they are negatively correlated how does it impact the portfolio diversification?
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Answer #1

As the standard deviation of a portfolio is given by

Where Wi is the weight of the security i,

is the standard deviation of returns of security i.

and is the correlation coefficient between returns of security i and security j

Negatively correlated stocks are better for portfolio diversification

From the formula,it can be seen that negative correlation coefficient would reduce the standard deviation of the Portfolio quite a lot which is the objective of portfolio (to reduce risk)

In fact , if there are perfectly negatively correlated stocks in a portfolio, the portfolio risk may be reduced upto zero.  

Hence the negatively correlated stocks help in portfolio diversification

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