Importance of Diversification in Portfolio Management

Hard Portfolio Risk And Return Portfolio Diversification

In the context of portfolio management, diversification plays a crucial role in mitigating risk and enhancing returns. Consider a portfolio consisting of three asset classes: equities, fixed income, and real estate. The correlation between these asset classes is as follows: equities and fixed income have a correlation of 0.2, equities and real estate have a correlation of 0.3, and fixed income and real estate have a correlation of 0.1. Given these correlations, assess the overall risk reduction achieved through portfolio diversification.

What is the primary reason for including multiple asset classes in a portfolio?

To ensure that all assets perform optimally regardless of market conditions.

To eliminate all unsystematic risk entirely and stabilize returns.

To decrease the overall volatility of the portfolio by reducing exposure to correlated asset movements.

Hint

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