Strategy Beginner: The Importance of Diversification

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1.
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.
2.
Diversification among asset classes can reduce the overall return of a portfolio because _______.
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Diversifying among different asset classes means including less-volatile assets that have lower expected earnings. Returns are averaged among all the securities in the portfolio.
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.
Investment portfolios can be called efficient when they ________.
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Contain the best possible mixes of assets for a specific risk level and return. Efficiency is relative to the kind of objective that you are trying to fulfill.
6.
The chance of experiencing inflation is an example of unsystematic risk.
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False. Inflation influences all companies as well as the entire economy. Diversification cannot eliminate the risk of facing inflation. Therefore, it is a systematic risk.
7.
A portfolio with negatively correlated assets reduces volatility.
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True. When some assets fall in value, others will rise in value, and vice versa.