Which of the following statements is most correct concerning diversification and risk?

Question

a. Risk-averse investors often choose companies from different industries for their portfolios because the correlation of returns is less than if all the companies came from the same industry.

b. Risk-averse investors often select portfolios that include only companies from the same industry group because familiarity reduces the risk.

c. Only wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks to gain the benefits of diversification.

d. Proper diversification generally results in the elimination of risk.

Answer 1

a.Risk-averse investors often choose companies from different industries for their portfolios because the correlation of returns is less than if all the companies came from the same industry. [True, investing in different industries that are negatively correlated decreases variation in the overall portfolio]

b. Risk-averse investors often select portfolios that include only companies from the same industry group because familiarity reduces the risk. [If they are in the same industry, they are likely to be affected by the same factors, highly correlated]

c. Only wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks to gain the benefits of diversification. [Diversification can be achieved by much fewer holdings]

d. Proper diversification generally results in the elimination of risk [no, proper diversifcation decreases unneeded risk for your desired return]

Answer 2

It would be B. The real secret to diversification is the minimum amount of diversification needed for optimal increase of capital and if you assume the log utility of value then a reasonable answer can be derived from engineering information theory. The concept of this optimal degree of acceptable risk has been discovered independently several times and is known by several names but the most recent would be The Kelly Capital Growth Investment Criterion. However this optimal point usually entails far more volatility then most investors are willing to undertake.

Answer 3

The answer is (a). If you have lots of different industries' stocks in your portfolio, you won't be dragged down just because one industry collapses, e.g. if you had put all your money on internet stocks, imagine what would have happened during the dot.com crash.