Why Low Correlation Drives Diversification
Course: Investment Planning
Lesson 13: Asset Allocation
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STUDENT QUESTION
I understand that diversification is supposed to reduce risk, and that low correlation between assets is what makes that work. But I'm having trouble seeing WHY low correlation reduces risk rather than just “smoothing out” the returns. If I own two stocks that don't move together, aren't I still exposed to the full risk of each one individually? It seems like I'd just be averaging my risk, not reducing it.
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INSTRUCTOR RESPONSE
I can see why you would think that. You're right that if two assets moved in perfect lockstep (correlation of +1), combining them would just average your risk — no benefit at all. But the less two assets move together, the more their swings offset each other rather than add together.
Take the extreme case we use here in the lesson: two stocks with equal risk and return, but perfectly inversely correlated. If one goes up $1, the other goes down $1, every time — so the portfolio's return never moves. That's not an average, it's a true offset, because the two returns work directly against each other.
Real assets are rarely that perfectly correlated, but the same idea applies on a smaller scale any time correlation is meaningfully below +1: a bad day for one holding is more likely offset by a different day for the other, which is what lowers portfolio volatility.
Let me know if that helps clarify it!
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