In order to maximize diversification, it is a good idea to
A. invest in large-, mid- and small – cap domestic mutual funds.
B. invest in international equity mutual funds.
C. invest in high-quality global bond mutual funds.
D. invest in all funds mentioned in A, B and C.
The correct answer and explanation is:
The correct answer is D. invest in all funds mentioned in A, B, and C.
Diversification is a strategy that reduces risk by spreading investments across different assets. By investing in a variety of asset classes and geographical regions, an investor can protect their portfolio from the poor performance of any single investment. Each asset class or region reacts differently to market conditions, and this can help reduce overall portfolio risk while enhancing the potential for returns.
A. investing in large-, mid-, and small-cap domestic mutual funds helps spread investments across different market capitalizations within the domestic market. Large-cap stocks tend to be more stable, while mid- and small-cap stocks can offer higher growth potential but also carry more risk. Having exposure to all three categories ensures a balanced approach to risk and return.
B. investing in international equity mutual funds further diversifies the portfolio by adding exposure to foreign markets. Different economies respond to varying factors, such as interest rates, political events, and currency fluctuations, so international funds can help protect against risks that may affect the domestic market alone.
C. investing in high-quality global bond mutual funds adds a fixed-income component to the portfolio. Bonds tend to behave differently than stocks, particularly in times of economic uncertainty. Global bonds, like international equities, offer diversification benefits by providing exposure to different countries and interest rate environments.
By combining investments from all three categories, an investor can achieve a higher level of diversification, reducing the overall volatility of the portfolio while improving the chances of achieving more stable returns over time. This balanced approach ensures that the portfolio is less reliant on the performance of any single asset class or geographic region.