CFA Level I · CFA Level I Exam · The Return and Risk of a Financial Portfolio
As more randomly selected securities are added to an equally weighted equity portfolio, the portfolio risk is most likely to decline because:
Portfolio risk declines mainly because idiosyncratic, security-specific risk is diversified away as holdings increase. Systematic market risk cannot be removed by adding securities, so risk falls toward a floor set by average covariance.
- Aidiosyncratic risk is gradually diversified awayCorrect
- Bsystematic risk is gradually diversified away
- Cexpected returns of securities become negatively correlated
Explanation
Security-specific risk is imperfectly correlated across holdings and averages out as the number of holdings rises. Systematic risk remains, and adding securities does not change their correlations.
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