Which of the following statements about correlation is correct?
A) If the returns from two stocks are perfectly positively correlated and the two stocks have equal variance, an equally weighted portfolio of the two stocks will have a variance, which is less than that of the individual stocks.
B) If a stock has a negative correlation with market, its systematic risk is more than the market risk.
C) Stocks with no correlation will have minimum diversification benefits.
D) The weaker the positive correlation two stocks exhibit, the more risk can be reduced when they are combined in a portfolio.
E) Risk is reduced when negatively related stocks are combined to form portfolios as long as the correlation coefficient is not equal to -1.

Question

Quizplus · Accepted Answer

The weaker the positive correlation between two stocks, the more diversification benefits can be obtained by combining them in a portfolio. This is because they are less likely to move in the same direction at the same time, reducing overall portfolio risk. Option A is incorrect as an equally weighted portfolio of perfectly positively correlated stocks will have a variance greater than that of the individual stocks. Option B is incorrect as a stock with negative correlation to the market has a lower systematic risk than the market. Option C is incorrect as stocks with no correlation will still have some diversification benefits when combined in a portfolio. Option E is incorrect as risk is reduced when negatively related stocks with a correlation coefficient of -1 are combined in a portfolio, not just as long as it is not equal to -1.

Which of the Following Statements About Correlation Is Correct