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NISM Certifications · NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors · Investments

Which of the following best describes the effect of adding an asset to a portfolio when its returns have a correlation of less than +1 with the existing holdings?

Portfolio risk is lower than the weighted average of the individual asset risks. Whenever correlation is below +1, the assets do not move perfectly together, so their fluctuations partly offset, which gives a diversification benefit without necessarily reducing expected return.

  1. APortfolio risk always rises above the weighted average of individual risks
  2. BPortfolio risk is lower than the weighted average of individual risksCorrect
  3. CPortfolio return always falls
  4. DPortfolio risk becomes exactly zero

Explanation

When correlation is below +1, diversification benefits arise, so portfolio standard deviation is less than the weighted average of the component standard deviations. Risk reaches zero only in special cases such as perfect negative correlation with suitable weights, not generally. Expected return is the weighted average and does not necessarily fall.

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