The diversifying effect of combining two assets in a portfolio is measured by what?

The diversifying effect of combining two assets in a portfolio is measured by the correlation coefficient. This statistical measure indicates how the returns of two assets move in relation to each other. A correlation coefficient close to +1 suggests that the assets tend to move together, which offers less diversification benefit. Conversely, a correlation coefficient close to -1 indicates that the assets tend to move in opposite directions, enhancing diversification benefits.

When constructing a portfolio, the goal is often to minimize risk while maintaining expected returns. By combining assets with low or negative correlation, an investor can reduce the overall volatility of the portfolio because the assets offset each other’s movements. Therefore, understanding and analyzing the correlation coefficient allows an investor to effectively gauge how diversifying two assets can impact the risk and return profile of the portfolio.