Which statement about portfolio diversification is true? a. Proper diversification can eliminate systematic risk. O b. The risk-reducing benefits of diversification will not occur if the risky assets are not correlated. C. Proper diversification can reduce the total risk to zero. d. • Diversification could reduce a portfolio’s total risk but does not affect the portfolio’s expected return. e. None of the options.
The Correct Answer and Explanation is :
The correct answer is:
d. Diversification could reduce a portfolio’s total risk but does not affect the portfolio’s expected return.
Explanation
Portfolio diversification is a key concept in modern portfolio theory, which suggests that investors can reduce their total risk by holding a mix of assets. Diversification works by combining assets with different risk-return profiles, thereby lowering overall portfolio volatility.
- Why Diversification Reduces Risk
Risk in investing is categorized into two types:
- Systematic risk (market risk): This includes factors such as economic downturns, interest rate changes, and political instability, which affect all securities in the market.
- Unsystematic risk (specific risk): This relates to factors affecting individual companies or industries, such as management changes, lawsuits, or product failures. Proper diversification can eliminate unsystematic risk by spreading investments across different asset classes, industries, or geographical regions. However, it cannot eliminate systematic risk, which affects the entire market.
- Why Diversification Doesn’t Affect Expected Return
Diversification can lower total risk but does not change the expected return of the portfolio. The expected return is primarily determined by the weighted average return of the individual assets in the portfolio. While risk is reduced through diversification, investors still require compensation for bearing systematic risk, which remains. - Why Other Options Are Incorrect
- (a) Incorrect: Proper diversification reduces unsystematic risk, but systematic risk cannot be eliminated.
- (b) Incorrect: The risk-reducing benefits of diversification only occur if assets are not perfectly correlated. If assets are perfectly correlated, they move in the same direction, making diversification ineffective.
- (c) Incorrect: While diversification reduces total risk, it cannot eliminate it completely.
- (e) Incorrect: Since option (d) is correct, “None of the options” is incorrect.
In conclusion, diversification helps reduce risk but does not increase or decrease the portfolio’s expected return.