Diversification
Before discussing diversification, we should first understand the correlation between the different investment opportunities. Correlation is the statistical measure of the relationship between any two series of numbers. The two series moving parallel in same direction will be positively correlated. And if two series are moving in opposite directions they will be negatively correlated.
We know that the returns of a portfolio can be maximized by diversifying the risk. And diversification totally depends upon the correlation of assets. In diversifying the portfolio for the purpose of reducing risk, correlation is best measure of risk attached with the proposed portfolio. Before making the portfolio, one must understand that the securities selected should be negatively correlated. Because the negative correlation means high diversification of portfolio and high diversification means more certainty of positive return from the portfolio.
Some assets are uncorrelated means there is no correlation between their returns. Combining uncorrelated assets can reduce risk but not so effectively than combining pure negatively correlated assets.Correlation, Diversification, Risk and Return
In general, the lower the correlation between assets return, the greater the potential diversification of risk. How much the risk of portfolio can be minimized depends upon the degree of correlation between the assets returns.
There are three types of combinations:
Positively correlated In which degree of correlation is greater than zero means low diversification so, risk will greater and return will uncertain.
Uncorrelated In which degree of correlation is approximately equals to zero means total diversification so risk will smaller and return will certain.
Negatively Correlated In which degree of correlation is less than zero means pure diversification so risk will eliminated and returns will higher.
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