relationship between portfolio components and correlation

Say a portfolio consists of two securities.

What correlation value would bring the most effective portfolio diversification?

I thought “0” would be the answer because I believe “-1” correlation means that if one’s return increases the other’s return decreases?

and “0” means there is no return relationship between two securities.

Please refer to PDF version 2017 level 1 mock exam : morning session question 112.

Negative one.

Only if the mean return of both securities is zero.

A correlation of returns of −1 means that when one security’s return is above its mean the other security’s return is below its mean and vice-versa. (It’s a little more restrictive than just this, but this captures the essential element.) They can both be positive if each security has a positive mean return.

First off, diversification is referring to the standard deviation of returns, not about expected returns.

More importantly, the portfolio standard deviation formula (for a two-asset case) has two sets of components: one is the component securities’ expected returns (again, not the returns in an individual state, but the overall average returns over all states). The other component is the “w1w2correlation1,2SD1SD2” term. The lower the correlation is, the more this reduces portfolio standard deviation. And since the limit for correlation is (-1), this is the case of minimum standard deviation (and therefore, for maximum diversification).

Shiny light?

Thank you a lot, guys! Appreciated!

s2000 - this is why I shouldn’t post later at night. And why it’s good we have you checking.