Work through why low correlation matters
Calculate how correlation changes portfolio volatility in a simple two-asset example.
Two funds each have 12% annual volatility. The proposed portfolio is 50% Fund A and 50% Fund B. Their correlation is 0.20. Estimate the portfolio volatility. Portfolio variance depends on weights, volatilities, and correlation: wA^2sA^2 + wB^2sB^2 + 2wAwBsAsBrho. The common shortcut is averaging standalone volatilities. That misses the covariance term and treats diversification as a headcount exercise. Step 1 Weights: wA = 0.50 and wB = 0.50 The portfolio gives equal capital to the two funds, so each fund's own variance is scaled by weight squared. Step 2 Individual variance terms: 0.50^2 0.12^2 + 0.50^2 0.12^2 = 0.0036 +…
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