Assume each of the asset classes below has the following correlation to long-term government bonds: Treasury bills: .67, Corporate bonds: .81, Large stocks: .37, Small stocks: .12. Which one of the following correctly states the impact of diversification on a portfolio of long-term government bonds?

Assume each of the asset classes below has the following correlation to long-term government bonds: Treasury bills: .67, Corporate bonds: .81, Large stocks: .37, Small stocks: .12. Which one of the following correctly states the impact of diversification on a portfolio of long-term government bonds?

• A. Treasury bills provide more diversification than small stocks.
• B. There is no diversification effect because all of the correlations are positive.
• C. Small stocks provide more diversification than large stocks.
• D. Corporate bonds provide more diversification than large stocks.

Answer: (C)

The response indicates that small stocks provide more diversification than large stocks based on their correlation with long-term government bonds. To understand why this is accurate, one must consider the concept of correlation in investment portfolios. Diversification is the practice of spreading investments across various asset classes to reduce risk. A key to successful diversification is investing in assets that are less correlated with each other; when one asset may be underperforming, another may perform better, balancing the overall portfolio performance. In this case, small stocks hold a correlation of .12 with long-term government bonds, which is significantly lower than the correlation of large stocks at .37. A lower correlation implies that small stocks do not move in tandem with government bonds, offering the potential for better risk management and a smoother return profile in a diversified portfolio. The positive correlation values indicate that, while there is some relationship between these asset classes and long-term government bonds, small stocks' correlation being the lowest signifies they can help in reducing overall portfolio risk more effectively compared to large stocks. The more disparate the movement between asset classes, the better the diversification effect becomes.

The response indicates that small stocks provide more diversification than large stocks based on their correlation with long-term government bonds. To understand why this is accurate, one must consider the concept of correlation in investment portfolios.

Diversification is the practice of spreading investments across various asset classes to reduce risk. A key to successful diversification is investing in assets that are less correlated with each other; when one asset may be underperforming, another may perform better, balancing the overall portfolio performance.

In this case, small stocks hold a correlation of .12 with long-term government bonds, which is significantly lower than the correlation of large stocks at .37. A lower correlation implies that small stocks do not move in tandem with government bonds, offering the potential for better risk management and a smoother return profile in a diversified portfolio.

The positive correlation values indicate that, while there is some relationship between these asset classes and long-term government bonds, small stocks' correlation being the lowest signifies they can help in reducing overall portfolio risk more effectively compared to large stocks. The more disparate the movement between asset classes, the better the diversification effect becomes.