The average observer would say that volatility of returns on the major stock averages is low because stocks are sticking close to their trend. Those that are rising, do not pull back. Those that are falling do not bounce, and many stocks are simply not moving around much at all. At the margin, we think this is probably true. But those who trade "volatility" know the true culprit is correlation. Volatility on stock indices tend to be high when correlation is high. That is, when most stocks move together. In cases like these, diversification does not reduce risk. The volatility of the portfolio is similar to the volatility of the stocks held by that portfolio. Take a look at the following equation. It shows the formula for a simple portfolio made up of 2 securities.
