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CFA Level I · CFA Level I Exam · Portfolio Risk and Return: Part I

An investor holds a risky portfolio and adds a new asset with a lower expected return than the portfolio, whose correlation with the portfolio is well below 1. The addition is most likely to:

Adding the asset will most likely reduce portfolio risk through diversification. Portfolio variance depends on correlations and covariances, not just weights or expected returns, so an asset with correlation well below 1 to the portfolio can lower overall risk even if it is risky by itself.

  1. Araise portfolio risk because the asset has a lower return
  2. Breduce portfolio risk through diversification, possibly even if the asset is individually riskyCorrect
  3. Cleave portfolio risk unchanged because only weights matter

Explanation

Portfolio risk depends on correlations as well as weights. An asset with a correlation well below 1 can lower portfolio variance even if it is risky on its own. Expected return alone does not determine its risk contribution.

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