Given below are two statements: One is labelled as Assertion (A) and the other is labelled as Reason (R).

​Assertion (A): If the securities with less than perfect negative correlation between their price movements are combined, portfolio risk can be reduced significantly.
​Reason (R): The term with negative correlation has the effect of reducing the computed value of total portfolio risk, given other terms that are positive.

In the light of the above statements, choose the most appropriate answer from the options given below:​

Correct option is A

Both Assertion and Reason are correct, and the Reason (R) correctly explains Assertion (A).

When two or more securities with less than perfect negative correlation (i.e., correlation < +1) are combined in a portfolio, their price movements do not move exactly in the same direction. This diversification effect leads to a reduction in overall portfolio risk, because the movement of one security may offset the movement of another.

The Reason correctly supports the Assertion. In the portfolio variance formula, the correlation coefficient between securities plays a key role. If the correlation is negative, the covariance term becomes negative, which reduces the total variance (or risk) of the portfolio. Therefore, Reason (R) accurately explains why combining such assets reduces portfolio risk.

Information Booster:

• Portfolio diversification is most effective when the included assets are not perfectly positively correlated.

• Even if the correlation is not fully negative (e.g., 0 or -0.5), risk reduction still occurs, though less than in the case of perfect negative correlation.

• Perfect negative correlation (-1) is the ideal case for eliminating risk entirely for two-asset portfolios.

• The correlation coefficient ranges from -1 to +1. Lower correlation implies better diversification.

• The key to reducing portfolio risk lies in the interaction between asset returns, not just individual risk levels.

• The impact of diversification is more visible in large portfolios where correlations between assets are carefully managed.