Which correlation scenario would provide the greatest reduction in portfolio risk when adding a new investment?

Which correlation scenario would provide the greatest reduction in portfolio risk when adding a new investment?

• A. large cap stock fund with a correlation of 1.0
• B. natural resource fund with a correlation of 0
• C. a managed futures fund with a correlation of -0.25
• D. a small cap fund with a correlation of 0.5

Answer: (C)

Diversification reduces portfolio risk when the new investment tends to move differently from the existing holdings. A negative correlation means the assets tend to move in opposite directions, which dampens overall volatility and lowers risk more than assets that move together. This option provides the strongest diversification because it has a negative correlation (-0.25) with the portfolio. When the portfolio's returns go up, this investment tends to go down, and vice versa, helping to smooth swings in the combined portfolio. The other choices have zero or positive correlations. Zero correlation still adds diversification, but not as effectively as a negative relationship. Positive correlations (0.5 and 1.0) mean the new investment tends to move in the same direction as the portfolio, offering little to no reduction—and can even increase—overall risk when added in.

Diversification reduces portfolio risk when the new investment tends to move differently from the existing holdings. A negative correlation means the assets tend to move in opposite directions, which dampens overall volatility and lowers risk more than assets that move together.

This option provides the strongest diversification because it has a negative correlation (-0.25) with the portfolio. When the portfolio's returns go up, this investment tends to go down, and vice versa, helping to smooth swings in the combined portfolio.

The other choices have zero or positive correlations. Zero correlation still adds diversification, but not as effectively as a negative relationship. Positive correlations (0.5 and 1.0) mean the new investment tends to move in the same direction as the portfolio, offering little to no reduction—and can even increase—overall risk when added in.