An investor holds 50 different technology stocks across companies ranging from large-cap to small-cap. A financial advisor says their portfolio is 'well diversified because it contains 50 holdings.' Is this correct?
AYes — 50 holdings is well above the threshold needed for diversification benefits
BNo — all 50 stocks are in the same sector and likely highly correlated, providing little diversification
CYes — holding both large-cap and small-cap stocks within a sector counts as diversification
DNo — you need at least 100 holdings before diversification benefits become meaningful
Diversification is not about the number of holdings — it is about correlation. If all 50 stocks are technology companies, they tend to rise and fall together: when the tech sector is hit by regulation, rising rates, or a downturn, all 50 decline simultaneously. True diversification requires assets with low correlations, spreading risk across sectors, geographies, and asset classes. Owning 30 tech stocks instead of 3 reduces company-specific risk slightly, but concentration risk in the sector remains high.
Question 2 Multiple Choice
In 2008, investors who held broad index funds containing thousands of stocks across many sectors still saw their portfolios drop 40–50%. What does this illustrate about diversification?
AIndex funds failed because they were not truly diversified across enough asset classes
BDiversification reduces unsystematic (company- and sector-specific) risk but cannot eliminate systematic (market-wide) risk
CDiversification only works as a risk-reduction strategy in rising markets
DThe 2008 crisis was exceptional; diversification normally prevents losses of this magnitude
Even a perfectly diversified portfolio across all equities cannot protect against systematic risk — events that affect the entire market, like a financial crisis, recession, or pandemic. Diversification eliminates unsystematic risk: the risk that one company or sector collapses while others remain healthy. To reduce systematic risk, you need to diversify across asset classes (adding bonds, real estate, commodities), which behave differently from equities during crises. The 2008 experience is not a failure of diversification — it is a reminder of what diversification can and cannot do.
Question 3 True / False
When you rebalance a portfolio that has drifted from its target allocation, you mechanically sell assets that have risen and buy assets that have become relatively cheaper.
TTrue
FFalse
Answer: True
True. If stocks have had a great year and your portfolio drifts from 70/30 stocks/bonds to 80/20, rebalancing means selling some stocks (which are now more expensive) and buying bonds (which are now relatively cheap). This is the buy-low-sell-high principle implemented automatically through a mechanical rule. While it feels counterintuitive to sell winners, it enforces discipline and prevents concentration from growing beyond your intended risk level.
Question 4 True / False
A perfectly diversified portfolio eliminates most investment risk.
TTrue
FFalse
Answer: False
False. Perfect diversification eliminates unsystematic risk — the risk tied to specific companies, sectors, or countries — but leaves systematic risk (market-wide risk) intact. Even an index fund holding every publicly traded stock in the world will decline in a global recession or financial crisis. To reduce systematic risk, you need to diversify across asset classes that respond differently to the same economic conditions (e.g., stocks and bonds, or adding real estate and commodities).
Question 5 Short Answer
Why does combining two imperfectly correlated assets reduce overall portfolio volatility without proportionally reducing expected return?
Think about your answer, then reveal below.
Model answer: When two assets are imperfectly correlated, their price movements do not perfectly align — when one falls, the other does not fall by the same amount (or may even rise). The losses in one asset are partially offset by the other, smoothing the combined returns. The portfolio's volatility (standard deviation of returns) falls because the offsetting movements cancel out some of the swings. But the expected return of the combined portfolio is still a weighted average of the two individual expected returns — there is no averaging-down of the return. This asymmetry — variance is reduced by more than the proportional blend would suggest, but expected return is not — is the core mathematical payoff of diversification.
The deeper reason is that portfolio variance depends on the covariance (correlation times the product of standard deviations) between assets, not just their individual variances. When correlation is below 1, the combined variance is less than the variance you would predict by simply blending them proportionally. At correlation = -1, variance can drop to zero while maintaining the average return — the theoretical maximum benefit of diversification.