Explain the role of correlation in portfolio risk. Which statement is correct?

• A. Correlation measures how asset returns move together; mixing assets with low or negative correlation reduces overall portfolio risk
• B. Correlation is identical to variance
• C. Correlation determines dividend payout
• D. Correlation measures liquidity

Answer: (A)

Correlation captures how asset returns move together. In a portfolio, you care about how the fortunes of different assets interact, not just how much each one can earn on its own. If two assets rise and fall in tandem, their movements reinforce each other and the portfolio’s total risk stays higher. If they tend to move in opposite directions or at least not in sync, they can offset each other, lowering the overall risk. This is the essence of diversification: combining assets with low or negative correlation reduces the portfolio’s risk beyond what you’d expect from looking at each asset alone. The math behind this is in the portfolio variance formula, where covariance terms (which depend on correlation) determine how the risks of individual assets combine. When correlations are low or negative, these covariance terms shrink and the portfolio variance decreases. So the correct statement is that correlation measures how asset returns move together, and mixing assets with low or negative correlation reduces overall portfolio risk. Correlation is not the same as variance, it doesn’t determine dividend payouts, and it isn’t a measure of liquidity.