Portfolio Diversification Strategies Flashcards

An investor holds 60% equities and 40% bonds. After a strong equity rally, the mix shifts to 75%/25%. The investor sells equities and buys bonds. This is best described as:

Answer: Threshold-based rebalancing

Threshold-based (or band) rebalancing triggers trades when an asset class drifts beyond a set tolerance band, regardless of the calendar date.

Which of the following best describes 'alternative investments' in a diversified portfolio?

Answer: Assets such as private equity, hedge funds, real assets, and infrastructure that have low correlation with traditional stocks and bonds

Alternative investments encompass non-traditional asset classes that typically exhibit low correlation with public equities and bonds, enhancing portfolio diversification.

A portfolio consists of 30 randomly selected stocks from the S&P 500. Compared to holding just 5 stocks, the 30-stock portfolio primarily reduces:

Answer: Idiosyncratic (unsystematic) risk

Increasing the number of stocks reduces company-specific (idiosyncratic) risk through diversification, while market-wide (systematic) risk remains.

What is the primary trade-off when using currency hedging in an internationally diversified portfolio?

Answer: Hedging reduces currency risk but adds cost and may remove a potential diversification source

Currency hedges reduce exchange rate volatility but incur hedging costs (like forward premiums) and can eliminate the diversification currencies themselves might provide.

Which portfolio scenario demonstrates 'naive diversification'?

Answer: Buying equal amounts of 20 stocks within the same sector without analyzing correlations

Naive diversification means spreading capital across many holdings without considering correlations, resulting in the illusion of diversification while actual risk reduction is minimal.

A certified pro trader wants to reduce the impact of unexpected inflation on a portfolio. Which asset class addition is most appropriate?

Answer: Treasury Inflation-Protected Securities (TIPS) or real assets

TIPS and real assets like commodities or real estate tend to perform well in inflationary environments, hedging against unexpected price-level increases.

What does the 'Sharpe ratio' measure in the context of portfolio diversification?

Answer: The excess return per unit of total risk (standard deviation), indicating risk-adjusted performance

The Sharpe ratio divides a portfolio's excess return above the risk-free rate by its standard deviation, measuring how efficiently risk is being compensated.