In our last post, we took a detour into the wilds of correlation and returned with the following takeaways:
Adding assets that are not perfectly positively correlated to an existing portfolio tends to lower overall risk in many cases.
The decline in risk depends a lot on how correlated the stocks are in the existing portfolio as well as how the additional stocks correlate with all the existing assets.
In our last post, we asked the simple question of whether an investor is better off being diversified if he or she doesn’t know in advance how a stock is likely to perform. We showed some graphs that suggested diversification lowered risk (or, more precisely, volatility), but this came at the expense of accepting less than maximal returns. We then showed that a diversified portfolio was able to produce better risk-adjusted returns on 8 out of 10 of the stocks we had randomly generated.