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On page 310 of Paper P1 KAPLAN study text under the subtopic – Diversifying/spreading risk it is stated thus – ” Diversification is works best where returns from different businesses are negatively correlated ie (move in different ways) It will, however, still work as long as the correlation is less than +1.0.” It is the second part (it wil, however, still work as long as the correlation is less than +1.0) this requires further expalnation. Could someone help with some examples please
If the correlation of revenues from two products is +1.0 and product 1 revenues decline by 20% product 2 revenues will also decline by 20%. A portfolio invested 50% in both products will therefore decline by 20%.
If the correlation of the revenues from the two products is +0.5 and product 1 revenues decline by 20% product 2 revenues will decline by 10%. A portfolio invested 50% in both products will therefore decline by 15%.
Even though the correlation in both portfolios is positive the second portfolio is less risky than the first.
@mikelittle said:
Check out your F2 notes!Are you implying that my answer is not correct?
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