Question

In a portfolio that contains two assets it is possible that there is no benefit to diversification from moving from a single asset to two assets. Why can this happen?
Select one:
a. It happens if returns on the assets in the portfolio are perfectly positively correlated.
b. It happens if each of the assets is a common share.
c. It happens if returns on one asset are negatively correlated with returns on the other asset.
d. The statement is incorrect – moving from a single asset to two assets always provides a benefit.
e. None of the above

Answer 1

a.It happens if returns on the assets in the portfolio are perfectly positively correlated.

The relatioship between correlation and diversification is that that lower the correlation, better the diversification. Correlation varies between -1 to +1. Maximum diversification is acheived when correlation is -1. As the correlation keeps increasing, diversification benefits decreases. If the correlation is perfectly positively correlated at +1, there wont be any diversification benefits.