Besides the specific return and risk variables of individual assets within a portfolio the correlation of returns between the individual assets are of relevance for the portfolio risk. Capital market theory suggests that diversification effects develop from return correlations with a correlation coefficient of lower than 1. Through the separation of systematic and unsystematic risk in a portfolio the combination of two assets with returns not completely positive correlated results in a risk reduction. Systematic risk represents the market risk, which affects equally all assets on all markets considered. Consequently, it can not be diversified away by spreading risk. Unsystematic risk, however, affects only specific assets, asset classes or homogenous sub-markets. It is related to the individual assets and with that the risk of the total portfolio may be balanced by a spreading different assets and their returns correlating as negative as possible. As shown in the graph below it decreases with an increasing number of assets in a portfolio.
Wellner, Kristin, and Matthias Thomas. "Diversification Benefits from European Direct Real Estate Investment with a Special Focus on the German Market." In 11th European Real Estate Society Conference. ERES: Conference. Milano, Italy, 2004.
Section: European Real Estate