Why Does Combining Volatile Assets Create Smoother Returns?

Updated November 2025

Volatility is often mistaken for risk. The sight of fluctuating prices provokes anxiety even when those movements cancel each other out over time.

Yet, paradoxically, combining two volatile assets can produce a smoother overall return than holding either in isolation. This apparent alchemy lies at the heart of modern investing - the principle of diversification.

The mathematics of covariance explains it; the philosophy of risk perception distorts it. This essay argues that when two assets move imperfectly together, their combined variance can be lower than either’s individual volatility, making the portfolio more stable.

However, it also explores why investors struggle to believe this counterintuitive truth, and how correlation, not volatility, is the true measure of danger.

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1. The Theory - Variance, Correlation, and the Portfolio Frontier

Harry Markowitz’s Modern Portfolio Theory (1952) provided the first formal answer. The total risk of a portfolio depends not only on the volatility of its components but also on how they move relative to each other.

The Portfolio Variance Formula

The formula for the variance of a two-asset portfolio is:

p² = wA²σA² + wB²σB² + 2wAwBσAσBρAB

Where ρAB is the correlation coefficient between Assets A and B.

If the correlation ρAB < 1, the combined portfolio’s variance is less than the weighted average of individual variances.

When ρAB = –1 — perfect inverse correlation — volatility can theoretically be eliminated altogether.

This is what your chart illustrates: two investments (A and B) moving in opposite directions offset each other’s peaks and troughs, yielding a near-straight line for the combination. Mathematically, volatility doesn’t add; it diversifies.

2. The Intuition - Offsetting Movements and the Geometry of Risk

Imagine two volatile rivers merging into one wider channel. Each river’s current surges independently; when one flows faster, the other slows, and their merger produces a steadier stream.

The same logic applies to asset returns: opposing movements dampen aggregate turbulence.

Equities and bonds offer a classic case. When stock markets fall during recessions, government bonds often rise as investors seek safety.

A 60/40 portfolio - though unfashionable in bull markets - has historically achieved lower drawdowns than pure equities, because the assets’ responses to macro shocks are opposite in sign.

In effect, diversification converts idiosyncratic volatility into systemic smoothness. The whole becomes less jittery than its parts.

3. The Statistical Reality - Correlation, Not Coincidence

The power of this principle depends entirely on correlation. If two assets move independently (correlation near zero) or inversely (negative correlation), combining them reduces risk. But if correlation rises as it often does in crises; diversification’s magic fades.

Historically, correlations between global equities and bonds were negative during most of the 2000s, providing strong diversification benefits. In 2022, when inflation surged, that correlation turned positive: both asset classes fell together.

Investors discovered that diversification is a conditional truth: it reduces risk across economic regimes, not across panic.

Thus, combining volatile assets produces smoother returns only when their drivers of volatility differ. The mathematics of variance becomes the sociology of capitalism: different companies, sectors, and asset classes respond differently to the same world.

4. Behavioural Finance - Why Investors Misunderstand It

If diversification is so powerful, why do so few investors exploit it fully? Because the human mind hates relativity.

a) Salience Bias

Investors fixate on individual winners and losers, not on portfolio-level outcomes. Seeing one holding fall feels like failure even if the portfolio as a whole is balanced.

b) Recency Bias

When two assets move differently, one will always look temporarily “wrong.” Investors abandon the laggard, destroying the offset that created smoothness.

c) Overconfidence

People prefer concentration; it flatters their sense of skill. Diversification feels like admitting ignorance.

Behaviourally, therefore, diversification feels riskier than concentration because it guarantees that part of one’s portfolio will always appear to be “losing.” The discipline required to maintain imperfectly correlated assets is intellectual, not emotional.

5. The Economics of Imperfect Correlation

True diversification rarely comes free. Assets that move in opposite directions often differ in expected return. For example, government bonds reduce volatility but also reduce long-run growth potential.

The art of portfolio design is therefore not to eliminate risk but to optimise the trade-off between risk and return. Markowitz called this the efficient frontier - the set of portfolios offering the highest expected return for each level of risk.

Combining two volatile assets produces a smoother path only when the reduction in variance outweighs the potential dilution in returns. The key lies in covariance management: combining assets whose risks are diverse rather than duplicated.

6. Real-World Illustrations - Oil & Airlines, Tech & Value

Concrete examples clarify theory.

Oil Companies vs Airlines

Oil prices rise, airline profits fall and vice versa. Holding both smooths the portfolio’s overall performance.

Technology vs Value Stocks

Tech thrives in low-rate growth phases; value performs better in inflationary cycles. A blend cushions regime shifts.

Equities vs Gold

Gold tends to rally during crises that crush equities, providing a stabilising counterweight.

These combinations, each individually volatile, collectively yield consistency through contradiction. That is the essence of intelligent diversification.

7. Limits of the Principle - When Diversification Fails

However, combining volatile assets can sometimes amplify rather than reduce risk.

High Positive Correlation

When all assets fall together as in 2008 or 2022 diversification offers little protection.

Liquidity Contagion

In crises, investors sell everything to raise cash, temporarily pushing correlations toward 1.

Illusion of Safety

Over-diversification (“diworsification”) dilutes returns without meaningfully lowering risk if assets share the same economic drivers.

Hence, combining two volatile assets is stabilising only when volatility arises from different sources of uncertainty. Diversity must be substantive, not cosmetic.

8. The Philosophical Dimension — Risk as Relationship

Ultimately, risk is relational, not absolute. A single asset’s volatility is meaningless without context. Two volatile assets can neutralise each other because their movements interlock like gears in a machine.

The smoother return of the whole is the product of interdependence, not isolation.

In this sense, diversification is less a financial trick than a philosophical insight: stability emerges not from stillness, but from the counterpoint of motion.

The Philosophy - Stability Comes From Counterbalance, Not Calm

A single asset’s volatility is meaningless without context.Two volatile assets can neutralise each other because risk is relational.

This is the foundational principle behind the Great Investments Programme:

Design portfolios where useful volatility cancels harmful volatility.

Check out Great Investments Programme → https://www.campaignforamillion.com/great-investments-programme

Investor tools → https://www.campaignforamillion.com/tools

Conclusion

Combining two volatile assets can yield a smoother return because their ups and downs offset each other when correlation is imperfect or negative.

The mathematics of covariance transforms volatility into resilience; the psychology of patience turns that resilience into wealth.

Diversification does not abolish risk, it rearranges it. What appears paradoxical is simply the arithmetic of independence: risk is not additive when its sources differ.

As the Great Investments Programme teaches, the goal is not to eliminate volatility but to design useful volatility - a portfolio whose fluctuations cancel rather than compound.

In the end, the smoothest journey often comes not from calm waters, but from the right balance of opposing tides.

Call to Action

If you want to build your own evidence-based, low-correlation portfolio, explore the free tools at: www.campaignforamillion.com/tools

Or start with the Great Investments Programme; designed to help you invest smarter, not riskier.

References: Markowitz, H. (1952). Portfolio Selection. Journal of Finance. Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision Under Risk. Ellis, C. (2017). The Index Revolution. Statman, M. (2019). Behavioural Finance: The Second Generation. Sharpe, W. (1994). The Sharpe Ratio. FAJ.

Disclaimer: This article is for education only and is not personalised financial advice. Investments can go down as well as up. Always consider your own circumstances or consult a regulated adviser. Alpesh Patel OBE www.campaignforamillion.com