Accredited Wealth Management Advisor Practice Exam

Which of these is correct regarding how diversification can affect risk?

1. Negative correlation of assets increases systematic risk with a corresponding increase in return.

2. Diversification of assets reduces unsystematic risk without necessarily reducing return.

3. Positive correlation of assets increases systematic risk with a corresponding increase in return.

4. Unsystematic risk is unaffected by diversification within an asset class.

The correct answer is: Diversification of assets reduces unsystematic risk without necessarily reducing return.

The assertion that diversification of assets reduces unsystematic risk without necessarily reducing return is valid and reflects a fundamental principle of investing. Unsystematic risk, which is the risk associated with a particular asset or group of assets, can be mitigated through diversification. By holding a variety of different assets, an investor can offset potential losses in one asset with gains in another, effectively mitigating the impact of any single investment’s poor performance on the overall portfolio. While diversification typically does not affect systematic risk—risk inherent to the entire market or a particular segment—it is crucial to acknowledge that the goal of diversification is primarily to minimize the potential for significant losses due to company-specific or industry-specific events. Therefore, while reducing risk is a core objective of diversification, it does not necessarily mean that returns will also decline; in fact, a well-diversified portfolio can lead to more stable returns over time. The incorrect options suggest misunderstandings about the relationship between asset correlation, risk, and return. Negative correlation increasing systematic risk or positive correlation affecting returns misrepresents how asset relationships play into overall portfolio risk management. Lastly, stating that unsystematic risk is unaffected by diversification within an asset class contradicts the core reasoning of diversification, as it indeed allows for risk reduction through