How Portfolio Diversification Reduces Risk
Diversification is the strategy of combining assets that don't move in sync. When stocks are perfectly correlated (ρ = 1), combining them gives no risk reduction. When they're negatively correlated (ρ = -1), risk can be nearly eliminated.
Portfolio Volatility Formula
σ_p = √(w1²×σ1² + w2²×σ2² + 2×w1×w2×σ1×σ2×ρ). The lower the correlation coefficient ρ, the more the portfolio volatility falls below the weighted average of individual volatilities — that gap is the diversification benefit.
Correlation Ranges
| Correlation | Meaning | Diversification |
|---|---|---|
| 0.7 to 1.0 | Strong positive | Low |
| 0.3 to 0.7 | Moderate positive | Moderate |
| -0.3 to 0.3 | Low correlation | Good |
| -1.0 to -0.3 | Negative correlation | High to Max |
Classic Low-Correlation Pairs
US stocks + bonds, growth + value stocks, domestic + international equities. These combinations tend to have lower correlations, providing meaningful diversification benefits in real portfolios.
FAQ
No — the calculator automatically normalizes the weights. Entering 60 and 40 gives a 60%/40% split; entering 3 and 1 gives 75%/25%.
This calculator handles two-asset portfolios. For three or more assets, a full covariance matrix is required. Use this for pairwise analysis or as a building block for larger portfolios.
※ Past correlation and volatility do not guarantee future results. Use as a reference only.