How do correlations between assets affect portfolio risk?

The correlation between assets plays a critical role in portfolio risk management. When evaluating how correlations affect portfolio risk, it is essential to understand that low or negative correlations between assets can indeed lead to a reduction in overall portfolio risk.

When assets in a portfolio have low or negative correlations, it means that their prices do not move in tandem. For instance, when one asset price declines, the other may remain stable or even increase. This behavior provides a balancing effect, stabilizing the portfolio's overall performance during market fluctuations. As a result, the portfolio is less susceptible to large swings in value because the movements of different assets offset each other.

In contrast, high correlations imply that the assets tend to move together. If all assets are correlated positively, they are likely to respond similarly to market conditions, which can exacerbate losses during downturns and lead to higher portfolio risk. By diversifying with assets that have low or negative correlations, an investor can achieve a more stable return profile and lower exposure to risk from adverse market conditions.

For these reasons, selecting assets with different correlations is a fundamental concept in portfolio construction aimed at risk mitigation.