A client has a portfolio consisting solely of large-cap U.S. equities. While the client is satisfied with the overall returns, they are concerned about the lack of diversification and potential for significant losses if the U.S. equity market experiences a downturn. Which of the following actions would best improve the portfolio's diversification and reduce systematic risk?
- AAdd small-cap U.S. equities to the portfolio.
- BIncrease the concentration in a single, high-growth large-cap U.S. stock.
- CAllocate a portion of the portfolio to international equities and fixed income.
- DInvest in more large-cap U.S. equities from different sectors.
Show answer & explanationAnswer & explanation
Correct answer: C. Allocate a portion of the portfolio to international equities and fixed income.
Diversifying into international equities and fixed income introduces assets that may have low correlations with U.S. large-cap equities, thereby reducing overall portfolio volatility and systematic risk. Investing in more large-cap U.S. equities or small-cap U.S. equities (options A and B) improves diversification within the U.S. equity market but does not significantly reduce systematic risk related to a broad U.S. market downturn. Increasing concentration (option D) would increase risk.
Why the other options are wrong
- A. Adding small-cap U.S. equities increases diversification within the U.S. equity market but may increase volatility and still leaves the portfolio highly exposed to U.S. systematic risk.
- B. Increasing concentration in a single stock dramatically increases unsystematic risk and does not address systematic risk or diversification concerns.
- D. Investing in more large-cap U.S. equities from different sectors improves sector diversification but does not reduce systematic risk to the overall U.S. equity market.
Systematic Risk (Market Risk)
The risk inherent to the entire market or market segment, affecting all assets to varying degrees. It is non-diversifiable, meaning it cannot be eliminated through diversification within a single market.
- Affects all investments.
- Caused by macroeconomic factors (e.g., interest rates, inflation, recessions).
- Cannot be eliminated through diversification within a single asset class or market.
- Can be reduced by diversifying across different asset classes and global markets.
Memory trick: Diversify globally, spread your risk broadly!