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What is the theory behind Rick Van Ness's risk calculation in the video about diversification?
The calculation and theory are explained in the other answers, but it should be pointed out that the video is the equivalent of watching a magic trick.  The secret is: "Stock A and B are perfectly negatively correlated."  The video glasses over that fact that without that fact the risk doesn't drop to zero. The rule is that true diversification does decrease risk. That is why you are advised to spread year investments across small-cap, large-cap, bonds, international, commodities, real estate. Getting two S&P 500 indexes isn't diversification.  Your mix of investments will still have risk, because return and risk are backward calculations, not a guarantee of future performance. Changes that were not anticipated will change future performance. What kind of changes: technology, outsourcing, currency, political, scandal.