Strategy Beginner: The Importance of Diversification

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1.
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.
2.
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.
3.
Risk tolerance is the amount of risk with which you are comfortable.
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True. It determines your choices of investments, among many other things.
4.
You have invested in a portfolio that has only two stocks. You observe that every time one stock goes up in price, the other goes down. The two stocks are _______ correlated.
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Negatively. Investments with prices that move opposite to each other are correlated negatively.
5.
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.
6.
In investing language, what does it mean to diversify?
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To divide your investments among a variety of assets. This can mean different types of assets, different industries, different countries, etc.
7.
Diversifying your stock portfolio among different companies or _______ can reduce risks that are specific to a company.
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Industries. Sometimes, a problem that hits one company in an industry can hit others in that industry.