Investment Portfolio Management and Diversification 1 — Questions and Answers
Question 1: What is diversification in investing?
- Investing all your money in the highest-performing stock
- Spreading investments across different asset classes to reduce risk (Correct answer)
- Changing investment strategies every month
- Investing only in foreign markets
Correct answer: Spreading investments across different asset classes to reduce risk
Diversification involves spreading investments across various asset classes, sectors, and geographies to reduce the impact of any single investment's poor performance on the overall portfolio.
Question 2: What is asset allocation?
- The process of selecting individual stocks within a portfolio
- The strategy of distributing investments among asset categories like stocks, bonds, and cash (Correct answer)
- The calculation of total investment fees
- A method for timing the stock market
Correct answer: The strategy of distributing investments among asset categories like stocks, bonds, and cash
Asset allocation is the process of dividing a portfolio among major asset categories such as stocks, bonds, and cash equivalents based on an investor's goals, risk tolerance, and time horizon.
Question 3: What does rebalancing a portfolio mean?
- Selling all underperforming assets immediately
- Adjusting the portfolio back to its target asset allocation after market movements shift the proportions (Correct answer)
- Moving all funds into the best-performing sector
- Opening new investment accounts to spread risk
Correct answer: Adjusting the portfolio back to its target asset allocation after market movements shift the proportions
Rebalancing restores a portfolio to its intended asset allocation by selling overweighted assets and buying underweighted ones after market fluctuations alter the original proportions.
Question 4: What is systematic risk?
- Risk that can be eliminated through diversification
- Market-wide risk that affects all investments and cannot be diversified away (Correct answer)
- Risk associated with a single company's operations
- The risk of a broker making an error on your account
Correct answer: Market-wide risk that affects all investments and cannot be diversified away
Systematic risk, also called market risk, affects the entire market or a large segment of it and cannot be reduced through diversification — examples include recessions and interest rate changes.
Question 5: What is the Sharpe ratio used for?
- Calculating dividend yield on a stock
- Measuring a portfolio's return relative to its risk, showing risk-adjusted performance (Correct answer)
- Estimating future earnings of a company
- Comparing bond yields across different maturities
Correct answer: Measuring a portfolio's return relative to its risk, showing risk-adjusted performance
The Sharpe ratio measures the excess return earned per unit of risk (standard deviation), helping investors evaluate whether a portfolio's returns justify the risks taken.
Question 6: What is dollar-cost averaging?
- Buying stocks only when prices drop below their average historical cost
- Investing a fixed dollar amount at regular intervals regardless of market price (Correct answer)
- Calculating the average cost basis for tax purposes
- Converting foreign currency dividends to U.S. dollars
Correct answer: Investing a fixed dollar amount at regular intervals regardless of market price
Dollar-cost averaging involves investing a consistent dollar amount at regular intervals, automatically buying more shares when prices are low and fewer when prices are high.
Investment Portfolio Management and Diversification 1
What is diversification in investing?