Question

5. Diversification reduces the overall risk of a portfolio because of a factor called correlation. Explain how a stock with a return standard deviation of 20% can be combined with a stock with a return standard deviation of 13.2% and result in a portfolio whose return standard deviation is much lower than the standard deviations of the two individual stocks? What is it about the correlation coefficient between stocks which reduces portfolio risk?

Answer 1

A Protfolio consisting of 2 or more stocks will have LOWER Standard Deviation that each individual stock, Provided that, the consisting stocks are NOT PERFECTLY correlated.

When the Correlation Co Efficient is 1 or -1, then it is said to be Perfectly Correlated.

Nearer the Correlation Co Efficient to 1 or -1, Higher they are Correlated and Lesser will be the Benefit of Diversification.

Nearer the Correlation Co Efficient to 0(whether Positive or Negative), Lesser they are Correlated and Higher will be the Benefit of Diversification.

In given case, if the Correlation between both the stocks is away from 1 or -1 and nearer to 0, say Correlation is 0.5 or -0.5, then tey are correlated. Advantage of Diversification can be taken by investing 50% in each stocks. By investing 50%-50% in each stocks, if Correlation is 0.5 or -0.5, then Standard Deviation of the Portfolio will be way below 13.2%.