Final answer:
To reap diversification benefits in a two-asset portfolio, the correlation coefficient between the asset returns should ideally be negative. Covariance has a greater influence on risk when adding an asset to a diversified portfolio, more so than the asset's individual standard deviation.
Step-by-step explanation:
In forming a portfolio of two risky assets, the correlation coefficient between their returns should be less than +1 to gain benefits from diversification. For there to be a significant benefit, ideally, the coefficient should be lower than zero, indicating a negative correlation where the assets' returns move in opposite directions. In such a case, the negative correlation helps in smoothing out the portfolio's return fluctuations over time.
When adding a risky asset to a diversified portfolio, the covariance of the new asset's returns with the existing portfolio's returns is more influential on the overall portfolio risk than the asset's standalone standard deviation. This is because covariance determines how the asset's returns move in relation to the returns of the portfolio; if the covariance is low or negative, it implies that the new asset can lower the portfolio's overall volatility, thus enhancing diversification benefits.