Which statement about diversification is true?

• A. Diversification benefits increase when asset correlations rise.
• B. Diversification benefits are unaffected by correlation.
• C. Diversification benefits decrease when asset correlations rise.
• D. Diversification benefits increase when asset correlations rise.

Answer: (C)

Diversification reduces risk by mixing assets that don’t move together. The strength of that risk reduction depends on how closely their returns are correlated. When correlations rise, assets tend to move in the same direction, so the portfolio’s overall volatility doesn’t drop as much as with lower correlations. In other words, the cross-effects that help damp risk become larger as correlation goes up, making diversification less effective. As correlations approach 1, the diversification benefits essentially vanish. That’s why the true statement is that diversification benefits decrease when asset correlations rise.