Assume Danny is considering combining two investments to form a portfolio, and he is very concerned with the risk that will result from the combination. If he wants to attain the greatest effect from diversification, he would prefer that the assets _____.
A)are negatively related
B)are positively related
C)are not related at all
D)have a negative coefficient of variation
E)have a positive coefficient of variation

Question

Assume Danny is considering combining two investments to form a portfolio, and he is very concerned with the risk that will result from the combination. If he wants to attain the greatest effect from diversification, he would prefer that the assets _____. 
A)are negatively related
B)are positively related
C)are not related at all
D)have a negative coefficient of variation
E)have a positive coefficient of variation

Quizplus · Accepted Answer

If the assets are negatively related, it means that they have a negative correlation coefficient or covariance. This implies that when one asset’s returns are high, the other’s are low. Therefore, combining these assets will result in a portfolio with lower risk, as their individual risks offset each other. Consequently, negative correlation helps to diversify risk, and Danny can expect the greatest effect from diversification by combining negatively related assets.

Assume Danny Is Considering Combining Two Investments to Form a Portfolio