A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

THE CORRELATION COEFFICIENT AND THE
ABILITY OF DIVERSIFICATION TO REDUCE RISK
Correlation
Coefficient
Effect of Diversification on Risk
+1.0
No risk reduction is possible.
+0.5
Moderate risk reduction is possible.
0
Considerable risk reduction is
possible.
–0.5
Most risk can be eliminated.
–1.0
All risk can be eliminated.
Now comes the real kicker; negative correlation is not
necessary to achieve the risk reduction benefits from
diversification. Markowitz’s great contribution to investors’

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wallets was his demonstration that anything less than perfect
positive correlation can potentially reduce risk. His research
led to the results presented in the preceding table. As shown,
it demonstrates the crucial role of the correlation coefficient in
determining whether adding a security or an asset class can
reduce risk.
DIVERSIFICATION IN PRACTICE
To paraphrase Shakespeare, can there be too much of a good
thing? In other words, is there a point at which diversification
is no longer a magic wand safeguarding returns? Numerous
studies have demonstrated that the answer is yes. As shown
in the following chart, the golden number for American
xenophobes—those fearful of looking beyond our national
borders—is at least fifty equal-sized and well-diversified U.S.
stocks (clearly, fifty oil stocks or fifty electric utilities would
not produce an equivalent amount of risk reduction). With
such a portfolio, the total risk is reduced by over 60 percent.
And that’s where the good news stops, as further increases in
the number of holdings do not produce much additional risk
reduction.

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