Portfolio diversification
Portfolio diversification reduces total risk by combining assets whose returns are imperfectly correlated, so that individual losses are offset by gains elsewhere. It removes unsystematic risk but cannot eliminate systematic risk.
FrameworkModern portfolio theory
See it move
A portfolio combining assets whose returns are imperfectly correlated sees its unsystematic risk fall away — illustratively 65% of total risk — as holdings spread across industries and geographies. The remaining 35%, systematic risk, comes from broad market forces every asset shares and cannot be diversified away. This is why the CAPM rewards investors for bearing beta, not total volatility.
Check yourself
Two securities each have an annual standard deviation of 15% and identical expected returns. An investor holds them in equal proportions. In which scenario does combining the two securities produce the greatest reduction in portfolio standard deviation compared with holding either security alone?