Question

What happens to portfolio variance when a. the correlation between securities decrease? b. the number of assets in the portfolio increases? (Assume correlation among assets are not perfect)

Answer 1

(a)

As the correlation between the securities decrease, the portfolio variance decreases

Because that means when one asset moves in one direction , the other asset in portfolio moves in opposite direction ( negative correlation), or moves less in the same direction ( positive correlation less than 1). So the total variability decreases

(b)

As the number of assets increases, portfolio variance decreases

As the number increases , more diversification is attained. We have assumed that no assets are perfectly correlated (correlation of 1). So adding any asset will reduce correlation and hence variance.

answered by: anonymous