Which of the following statements about portfolio diversification is/are correct

Question

Which of the following statements about portfolio diversification is/are correct? a. Risk averse investors require a rate of return of zero for a risk free security b. Diversification is most effective when securities returns are negatively correlated c. Typically, as more securities are added to a portfolio, total risk would increase at a decreasing rate d. Because diversification reduces a portfolio's total risk, it necessarily reduces the portfolio's expected return. e. Both a and d are correct.

Explanation / Answer

Correct option is > b. Diversification is most effective when securities are negatively correlated.

Reason: Negatively correlated securities add true diversification to portfolio. The stock negatively correlated compensates returns of other stocks which are correlated and in adverse scenarios generate bad returns.

Other options: Risk averse investor require rate is more than zero. Govt securities yield risk free rate and that’s risk averse investor desires. Adding securities would not increase risk in general. Diversification reduces portfolio risk that doesn’t implies it impacts expected return all time.

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