A portfolio manager can reduce risk by diversifying the assets in the portfolio.

Diversification is ideal when the second asset that is added to the portfolio is negatively co-related to the first asset. This ensures during tough times for the first asset, the second asset will perform well and vice versa. Ultimately the manager will not suffer huge losses if the assets are negatively co-related.

To explain the effect of co-relation coefficient, let us consider the formula for the variance of a 2- asset portfolio:

Variance = (Weight of asset 1 * Standard deviation of asset 1 )²+ (Weight of asset 2 * Standard deviation of asset 2)² + (2* Weight of asset 1 * Standard deviation of asset 1 * Weight of asset 2 * Standard deviation of asset 2 * Correlation coefficient)

So we can see from the above formula that if the correlation coefficient is negative ( between 0 and -1) the Variance will be lower and if it is -1 , then the 2 assets are perfectly negative co-related. and the variance or Standard deviation of the portfolio will be the minimum.

Hence, correlation coefficient concept is important to reduce risk