The Lower the Correlation, the More Diversification Cuts Your Risk
The whole point of spreading money across multiple assets comes down to correlation. The less two assets move alike, meaning the lower or more negative their correlation, the more one can offset losses in the other, shrinking the swings in your overall portfolio. What's notable is that this combined volatility ends up lower than a simple weighted average of each asset's own volatility, and that gap is exactly the risk-reduction benefit diversification creates.
How It's Calculated
| Item | Formula |
|---|---|
| Weighted average volatility | wA x volA + wB x volB |
| Portfolio volatility | sqrt(wA^2 x volA^2 + wB^2 x volB^2 + 2 x wA x wB x rho x volA x volB) |
| Diversification effect | Weighted average volatility - portfolio volatility |
Correlation (rho) ranges from -1 to +1: at +1 there's no diversification benefit, and the closer it gets to -1, the more risk it can theoretically cut. For example, blending a volatile stock with a lower-volatility bond at a correlation of 0.3 noticeably lowers portfolio volatility below the simple average. Keep in mind that correlations tend to rise together during sharp downturns, so treat this as a useful estimate rather than a guarantee.
Frequently Asked Questions
When one asset falls, the other tends to fall less or rise, offsetting losses, so combined volatility ends up lower than a simple weighted average.
From -1 to +1. +1 means perfect co-movement (no benefit), 0 means no relationship, -1 means perfectly opposite, theoretically the biggest risk cut.
Yes, to some degree, as long as correlation isn't exactly 1. But it weakens in sharp downturns, when correlations tend to converge.
* Based on historical volatility and correlation; does not guarantee future risk, estimate for reference only.