Diversification Benefits
A diversification benefit exists when a portfolio’s standard deviation can be reduced without reducing expected return.
The diversification benefit is possible when return correlations between portfolio assets is less than perfect positive correlation (<+1.0).
If assets have less than a +1.0 correlation, then some of the random fluctuation around the expected trend rates of return will cancel each other out and lower the portfolio’s standard deviation (risk).
If assets have a perfect negative correlation (-1.0), then some combination of asset weights will eliminate all of the portfolio’s expected standard deviation (risk).
As the number of assets grows large, the variance of the portfolio will approach the average covariance of the asset pairs comprising the portfolio; this is the upper limit of portfolio diversification benefits.
Covavg = (ρavg \* σavg2)
An analyst can assess how the variance (and standard deviation) of a portfolio will decline by adding more assets with following formula:
1σport new2 = σcurrent2 (
Test Your Knowledge
Check your understanding of this lesson with a short quiz.