Question

.Suppose short sales are prohibited. Some diversification benefits can be achieved by combining securities in a...

.Suppose short sales are prohibited. Some diversification benefits can be achieved by combining securities in a portfolio as long as the correlation between the securities is Less than 1.

Why?

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Answer #1


When short selling is prohibited then we can use low correlation stocks to diversify the portfolio.

Diversification means allocating funds to various financial instruments which have different risk profiles.

Diversification is achieved through selecting stocks which have low correlation with existing portfolio. The low correlation (means lower than 1.0) means that stock to be added in portfolio will not have same risk profile as existing. Stock with low correlation (i.e. correlation less than 1) with existing portfolio will achieve true diversification hence, diversification reduces the risk of the portfolio of an investor.

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