Question

How does the creation of a portfolio reduce risk? What type of assets should be included in a diverse portfolio? Why should they be included?

Answer 1

Creation of a portfolio reduces risk when the assets in the portfolio have low or negative correlation. This is because the prices of the assets are less likely to move together. As the asset prices are less likely to move in the same direction, the overall portfolio volatility is reduced because the losses on one assets are offset by the gains on another assets.

In a diverse portfolio, assets with low or negative correlation should be included. This will reduce the overall portfolio volatility (risk).