CFA Practice Question

There are 294 practice questions for this study session.

CFA Practice Question

Adding another security to a portfolio of stocks will reduce the risk of the portfolio if the additional security ______

A. has returns that are negatively correlated with the other stocks in the portfolio.
B. is from an industry that is already represented in the portfolio.
C. is from an industry that is not already represented in the portfolio.
D. has returns that are positively correlated with the largest holdings in that portfolio.
Correct Answer: A

User Contributed Comments 8

User Comment
julescruis I would have answered B as well as this type of investment would have more probability of being negatively correlated
ljamieson but choice of assets/sector is not a random variable. you search for assets that are negatively correlated to your portfolio to increase diversification and reduce risk.
soarer1 Negative correlation = opposite direction (cancellation effect)
Positive correlation = same direction (no cancellation effect)
hannovanwyk B cannot be correct, a different industry could still have the same correlation.
jonan203 for purposes of this question i can see how A is the correct answer; however, if you have a portfolio of 10 gold mining stocks adding another gold mining stock still reduces the risk of the portfolio.

if you equal weight the 10 mining stocks and one goes bankrupt, you wouldn't lose as much money with a gold mining portfolio with 11 equal weight stocks in which the same company goes bankrupt.

bankruptcy risk reduced, not to mention strike risk, regional risk, appropriation risk of gold firms in politically unstable nations, enviornmental risk, known reserves risk, political risk, etc
gill15 B's wrong...BUT what about C?

From another industry -- correlation coefficient will NOT be 1 -- therefor portfolio variance will be reduced.
SKIA Gill15 - C is a correct answer as well, but the BETTER answer is A. A states that the stock is negatively correlated. However, in C it just states a stock from another industry, if the two industries were related they could have a positive correlation. Take for example a company that only sells mulch and a company that only sells flowers. They are in different industries, but they most likely are correlated in terms of performing better in the summer and weaker in the winter.
chesschh SKIA, C is not always correct. A different industry may be positively correlated which would make the portfolio riskier
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