Question

5. Portfolio risk and diversification

A financial planner is examining the portfolios held by several of her clients. Which of the following portfolios is likely to have the smallest standard deviation?

A portfolio with 10 randomly selected U.S. stocks.

A portfolio with 10 randomly selected international stocks.

A portfolio with 10 randomly selected stocks from U.S. and international markets.

Portfolio managers pick stocks for their clients’ portfolios based on the investment objective of the portfolio and several other factors. One key consideration is each stock’s contribution to portfolio risk and its statistical relationship with the portfolio’s other stocks.

Based on your understanding of portfolio risk, identify whether each statement is true or false.

Statement	True	False
Because of the effects of diversification, the portfolio’s risk is likely to be smaller than the average of all stocks’ standard deviations.
The portfolio’s risk is the weighted average of the individual stocks’ standard deviations.
Portfolio risk will decline if more stocks that are negatively correlated with other stocks are added to the portfolio.
The market risk component of the total portfolio risk can be reduced by randomly adding stocks to the portfolio.

Answer 1

1.
A portfolio with 10 randomly selected stocks from U.S. and international markets.

2.
True

3.
False

4.
True

5.
False