CPT Portfolio Diversification Strategies 3 — Questions and Answers
Question 1: Which diversification strategy involves spreading investments across different points in time to reduce timing risk?
- Sector rotation
- Dollar-cost averaging (Correct answer)
- Tactical asset allocation
- Factor investing
Correct answer: Dollar-cost averaging
Dollar-cost averaging reduces timing risk by investing fixed amounts at regular intervals, buying more shares when prices are low and fewer when prices are high.
Question 2: Which asset class historically has the lowest correlation with U.S. large-cap equities, providing the greatest diversification benefit?
- U.S. small-cap stocks
- Investment-grade corporate bonds
- Commodities (Correct answer)
- U.S. real estate investment trusts (REITs)
Correct answer: Commodities
Commodities tend to have low or negative correlation with equities, especially during inflationary periods when stocks struggle.
Question 3: A portfolio has a correlation of -1 between its two assets. What happens to portfolio variance as weight shifts between them?
- Portfolio variance always equals the average of the two individual variances
- Portfolio variance can theoretically be reduced to zero at the optimal weighting (Correct answer)
- Portfolio variance increases as you move toward an equal-weight mix
- Portfolio variance is unchanged regardless of weighting
Correct answer: Portfolio variance can theoretically be reduced to zero at the optimal weighting
With perfect negative correlation, there exists a specific weighting combination at which the two assets' movements completely offset each other, yielding zero portfolio variance.
Question 4: An investor uses a 'core-satellite' approach. The core allocation typically consists of:
- High-risk speculative positions designed to outperform benchmarks
- Broad, low-cost, passively managed index funds providing market exposure (Correct answer)
- Alternative assets such as private equity and hedge funds
- A concentrated bet on a single high-conviction theme
Correct answer: Broad, low-cost, passively managed index funds providing market exposure
In a core-satellite portfolio, the core is a diversified, low-cost passive base, while satellites are active or alternative positions seeking alpha.
Question 5: What does 'geographic diversification' primarily protect against?
- Inflation risk in all countries simultaneously
- Currency appreciation eating into foreign returns
- Country-specific economic downturns, political instability, and regulatory changes (Correct answer)
- Interest rate movements in the domestic market
Correct answer: Country-specific economic downturns, political instability, and regulatory changes
Geographic diversification reduces the impact of adverse events in any single country, such as recession, political upheaval, or abrupt regulatory shifts.
Question 6: Which measure captures the portion of portfolio risk that cannot be eliminated through diversification?
- Idiosyncratic risk
- Systematic risk (Correct answer)
- Liquidity risk
- Default risk
Correct answer: Systematic risk
Systematic (market) risk affects all assets broadly and cannot be diversified away, unlike idiosyncratic risk which is security-specific.
Question 7: A trader notices that during the 2020 COVID crash, almost all asset classes fell simultaneously. This phenomenon is known as:
- Diversification bonus
- Correlation convergence (or contagion) (Correct answer)
- Portfolio rebalancing
- Alpha decay
Correct answer: Correlation convergence (or contagion)
During extreme market stress, correlations between asset classes tend to spike toward 1 as panic selling affects all markets simultaneously, reducing diversification benefits.
CPT Portfolio Diversification Strategies 3
Which diversification strategy involves spreading investments across different points in time to reduce timing risk?