Question

What is the role of correlation in portfolio stock diversification?

Answer 1

The crux of portfolio diversification is the existence of a correlation between the differtent stocks in the market. Had there been no correlation between the stocks, the whole idea of diversification is will be useless as there will be no reduction in the overall risk of the portfolio. Infact, in such a case where there is no correlation, the portfolio risk will be simple weighted average risk of the individual stocks in the portfolio.

The role of a "correlation " in the management of a portfolio of stocks is that it reduces the overall portfolio risk by setting off negative returns in few stocks with the positive returns in other stocks , at any particular point of time. Due to the existence of correlation between the stocks, the stocks move in different direction ps with respect to the movement in market index. Hence, the opposite movement within the stocks in a portfolio brings in the setting-off effect, thereby reducing the overall portfolio risk. The more opposite the movement in the stock returns with respect to the movement in the market index, the lower will the overall portfolio risk.