Question

Explain the relationship between correlation, diversification, and risk reduction. What is wrong with a 100% domestic stock portfolio and how can you fix it

Answer 1

Correlation will be reflecting the relationship of rate of return between two Assets and if there is a higher positive correlation between two assets which will be offering us with a very low opportunity of diversification.

whenever there is a very low positive correlation or Nil correlation between rate of return of two assets, it will offer an optimum chance of optimum diversification and we can reduce the firm specific risk.

when there will be a higher diversification in the portfolio, it will mean that systematic risk will be eliminated to the largest possible extent and when there will be a lower diversification in the portfolio, it will mean that there would be a presence of higher risk

When we are positioning ourselves with 100% of domestic assets in our portfolio, it will not be offering us with any diversification related to foreign exchange fluctuations so we should always be trying to diversify ourself into multiple assets across multiple countries because it will be offering us with high level of diversification various firm-specific risk.