CFA Level I Exam · Portfolio Management: An Overview

Portfolio Approach and Diversification: How Diversification Reduces Risk

Updated 7 October 2026 · Fact-checked

The portfolio approach judges every holding by how it changes the risk and return of the whole portfolio, not by its stand-alone result. Diversification combines assets that do not move perfectly together, so some risk cancels out. It removes unsystematic risk but cannot remove systematic risk.

Understand Portfolio Approach and Diversification

Start with a simple idea. If you hold one stock, your outcome depends on that one company. If it fails, you lose a lot. The portfolio approach asks a different question: what does each asset do to the whole pool of investments?

This matters because assets rarely move in lockstep. When one falls, another may rise or fall less. The combined return is the weighted average of the individual returns. But the combined risk is usually lower than the weighted average of the individual risks. That gap is the benefit of diversification.

The size of the benefit depends on correlation. If two assets have a correlation of +1, there is no risk reduction from mixing them. The lower the correlation, the larger the reduction. With a correlation of -1 and the right weights, risk can in theory fall to zero. In practice, correlations between most assets are positive but below 1, so you get a partial benefit.

Risk splits into two parts. Systematic risk (market risk) comes from forces that affect all assets, such as recessions, interest rate shifts or inflation. It cannot be diversified away. Unsystematic risk (firm-specific or idiosyncratic risk) comes from events at one company or industry, such as a product recall. Adding more assets spreads these events out and removes most of this risk.

So diversification does not guarantee profit or protect you in every crash. It improves the risk-adjusted return: you get a similar expected return for less risk, or more return for the same risk. Correlations can also rise in market stress, so the benefit may shrink when you need it most.

Key formulas to remember

Portfolio expected return: E(Rp) = Σ wᵢ × E(Rᵢ); A weighted average of asset expected returns. Weights sum to 1. Diversification does not reduce this.
Two-asset portfolio variance: σp² = w₁²σ₁² + w₂²σ₂² + 2 w₁ w₂ ρ₁₂ σ₁ σ₂; Standard deviation is the square root. The correlation term ρ₁₂ drives the diversification benefit.
Perfect positive correlation case: σp = w₁σ₁ + w₂σ₂ when ρ₁₂ = +1; Risk is just the weighted average of the risks. No diversification benefit.
Total risk decomposition: Total risk = Systematic risk + Unsystematic risk; Diversification removes unsystematic risk. Systematic risk remains.

How to solve Portfolio Approach and Diversification questions

Use this method for conceptual and numerical questions on the portfolio approach and diversification.

1Identify what is asked: return, risk, or the type of risk (systematic or unsystematic).
2If it is a return question, use the weighted average of expected returns. Correlation does not matter here.
3If it is a risk question, check the correlation. At +1, risk is the weighted average of standard deviations. Below +1, portfolio risk is lower than that.
4For a numerical risk question, compute the variance using the two-asset formula, then take the square root only at the end.
5For a risk-type question, ask: does this event hit the whole market, or one firm or industry? Market-wide is systematic. Specific is unsystematic.
6Check which option fits the rule: diversification reduces unsystematic risk, not systematic risk, and does not change expected return.
7Eliminate the two options that break these rules, then choose the remaining one.

Quickest way: Correlation and risk-type shortcut

When to use it: Use for most conceptual questions and for quick checks on numerical ones.

Ask first: is the question about return or risk? Return is a simple weighted average.
If correlation is +1, risk is a simple weighted average. Any option showing lower risk is wrong.
If correlation is below +1, expect portfolio risk to be below the weighted average of risks.
Sort the risk: market-wide means systematic, firm-specific means unsystematic.
Reject any option that says diversification removes systematic risk or guarantees gains.

Common mistakes in Portfolio Approach and Diversification

Saying diversification reduces expected return.
Students link lower risk with lower return.
Fix: Expected portfolio return is the weighted average of asset returns. Diversification lowers risk without changing that average.
Believing diversification can remove all risk.
The word sounds like 'spread out until safe'.
Fix: Only unsystematic risk can be diversified away. Systematic risk stays, because every asset is exposed to it.
Taking the weighted average of standard deviations for any portfolio.
It works for returns, so students copy it for risk.
Fix: That shortcut is correct only when correlation is +1. Otherwise use the variance formula.
Forgetting to take the square root at the end.
The formula gives variance, and students stop there.
Fix: Compute σp² first, then take √ to get standard deviation. Check whether the question asks for variance or standard deviation.
Classing a recession or interest rate rise as unsystematic risk.
Students focus on how it hurts one company.
Fix: If the event affects the whole market or many asset classes, it is systematic, whatever it does to one firm.
Assuming diversification works the same in all markets.
Correlations are treated as fixed numbers.
Fix: Correlations can rise in stress periods, so the benefit can shrink in a crisis.

Worked examples

Example 1

Asset X has an expected return of 8% and a standard deviation of 10%. Asset Y has an expected return of 12% and a standard deviation of 20%. A portfolio holds 50% in each, and the correlation is 0.5. What is the portfolio standard deviation? A) 12.2% B) 13.2% C) 15.0%

Show the solution

Variance = (0.5² × 0.10²) + (0.5² × 0.20²) + 2 × 0.5 × 0.5 × 0.5 × 0.10 × 0.20.
First term: 0.25 × 0.01 = 0.0025.
Second term: 0.25 × 0.04 = 0.0100.
Third term: 2 × 0.5 × 0.5 × 0.5 = 0.25, and 0.25 × 0.02 = 0.0050.
Variance = 0.0025 + 0.0100 + 0.0050 = 0.0175.
Standard deviation = √0.0175 = 0.13229, or 13.2%.
Computed value is 13.2%, so B is correct; C (15.0%) equals the weighted average, which applies only at correlation +1.

Answer: B) 13.2%

Example 2

A portfolio manager adds 30 more stocks from different industries to a portfolio of 10 stocks. Which statement is most likely correct? A) Systematic risk falls sharply because the portfolio is larger B) Unsystematic risk falls, while systematic risk remains C) Expected return falls because the portfolio has more holdings

Show the solution

Adding many assets across industries spreads out firm-specific events.
Firm-specific events are unsystematic risk, so that risk falls.
Systematic risk comes from market-wide forces that hit every stock, so more holdings do not remove it. A is wrong.
Expected return is a weighted average of the assets' returns. Adding assets does not make it fall by itself. C is wrong.

Answer: B) Unsystematic risk falls, while systematic risk remains

Exam tips

Read the question for 'return' versus 'risk'. Many traps swap the two.
If a numerical risk answer exceeds the weighted average of standard deviations and correlation is below 1, it is wrong.
Use your calculator memory to store variance terms, then press √ last.
Words like 'eliminates all risk' or 'guarantees' usually signal a wrong option.
With three options, sort each risk example into market-wide or firm-specific, then eliminate fast.

Practice questions from Portfolio Management: An Overview

Portfolio Approach and Diversification in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Portfolio Approach and Diversification: frequently asked questions

What is the difference between systematic and unsystematic risk?

Systematic risk comes from market-wide factors such as interest rates or recessions, and it cannot be diversified away. Unsystematic risk is specific to a firm or industry. Holding many different assets reduces it.

How does diversification reduce portfolio risk?

Assets with less than perfect correlation do not all fall at the same time. Losses in one are partly offset by gains or smaller losses in others. This makes the portfolio's standard deviation lower than the weighted average of the asset risks.

Why is the portfolio approach better than judging securities individually?

An asset's stand-alone risk can be misleading. What matters is how it changes the risk of the whole portfolio, which depends on its correlation with other holdings. A risky asset with low correlation can lower overall risk.

Does diversification work if correlation is +1?

No. At a correlation of +1, portfolio standard deviation equals the weighted average of the individual standard deviations. You get no risk reduction from mixing the assets.