Strategy Beginner: The Importance of Diversification

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1.
For a given investment return, there are optimal mixes of stocks, bonds, and cash that produce different returns with a minimum of risk.
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True. These portfolios are called "efficient." Their optimality has been demonstrated by analyzing returns over history.
2.
The risk of the company in which you invest being destroyed by a passing tornado is an example of _______ risk.
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Unsystematic. A tornado is a natural disaster that is unlikely to affect all industries; hence, it is an unsystematic risk.
3.
A slump in one industry can actually help other industries.
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True. In industries that meet similar needs, people may use the products or services of another industry if their preferred one experiences major problems. For instance, if there are problems in the airline industry, transportation needs may be met by driving or using trains.
4.
How does having a lot of money affect your risk tolerance?
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It can enable you to afford loss. If you have a lot of money, you can afford to lose some, and so your risk tolerance will increase.
5.
Diversification helps to reduce risk because _______.
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Different investments perform differently. The idea behind diversification is that the changes in differently performing investments will cancel each other out.
6.
Which of the following can reduce volatility in investing?
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Negative correlation of securities. A fall in one type of security can be offset by a rise in another.
7.
Why does diversifying across different classes of assets help reduce risk?
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Different classes of assets respond differently to economic events. Each type of asset (stocks, bonds, cash, real estate, etc.) has its own risks that may not exist for other types of assets.