How does correlation influence portfolio diversification?

• A. Lower or imperfect correlation among assets leads to greater diversification benefits and reduced overall risk.
• B. Higher correlation increases diversification benefits.
• C. Correlation has no impact on portfolio risk.
• D. Diversification always increases risk.

Answer: (A)

Correlation shows how asset returns move relative to each other. Diversification works best when assets don’t move in lockstep. Lower, or imperfect, correlation means the upturns in some assets can offset the downturns in others, so combining them lowers the overall portfolio risk. In technical terms, a portfolio’s variance depends on both the individual volatilities and the covariances between assets; when covariances (driven by correlation) are smaller, the total variance drops, improving risk reduction.

If assets are highly correlated, their movements reinforce each other, so adding them doesn’t reduce risk much. Saying correlation has no impact would ignore the very mechanism that diversification relies on, and claiming diversification always increases risk contradicts the fundamental idea that spreading risk across differently behaving assets tends to lower overall volatility.