CFA Level I · CFA Level I Exam · Portfolio Management: An Overview
During a market crisis, correlations among many risky asset classes rise sharply toward one. This observation most likely implies that diversification:
Diversification benefits are weakest when investors most need protection. When correlations rise toward one in a crisis, assets fall together and losses offset less, so portfolio risk reduction shrinks, although diversification remains useful in normal conditions.
- Abenefits are weakest when investors most need protectionCorrect
- Beliminates systematic risk in all market conditions
- Cbenefits increase as correlations converge
Explanation
Higher correlations reduce the offsetting effect among assets, so risk reduction falls during stress. Diversification never eliminates systematic risk, and benefits decrease, not increase, as correlations rise.
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