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30 April, 2015 - 10:37

An investor can reduce portfolio risk simply by holding combinations of instruments which are not perfectly positively correlated (correlation coefficient  -1 \le \rho_{ij}< 1). In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification may allow for the same portfolio expected return with reduced risk. These ideas have been started with Markowitz and then reinforced by other economists and mathematicians such as Andrew Brennan who have expressed ideas in the limitation of variance through portfolio theory.

If all the asset pairs have correlations of 0—they are perfectly uncorrelated—the portfolio's return variance is the sum over all assets of the square of the fraction held in the asset times the asset's return variance (and the portfolio standard deviation is the square root of this sum).