NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesMedium
A client has a portfolio primarily composed of U.S. large-cap equities. To reduce overall portfolio risk and enhance diversification, the investment adviser recommends adding an asset class that historically has a low correlation with domestic stocks. Which of the following asset classes would be most suitable for this purpose?
- ADomestic real estate investment trusts (REITs).
- BDeveloped international equities.
- CAdditional U.S. large-cap growth stocks.
- DSmall-cap U.S. value stocks.
Show answer & explanationAnswer & explanation
Correct answer: B. Developed international equities.
To reduce overall portfolio risk and enhance diversification for a client with a primary holding in U.S. large-cap equities, adding an asset class with a low correlation is key. Developed international equities often exhibit lower correlation with domestic stocks compared to other domestic equity styles, providing effective diversification benefits.
Why the other options are wrong
- A. Domestic REITs, while offering some diversification benefits as a distinct asset class, still have a significant correlation with the broader U.S. equity market, especially during economic downturns.
- C. Adding more U.S. large-cap growth stocks would increase concentration in an already dominant asset class, not enhance diversification.
- D. While small-cap U.S. value stocks offer diversification within the U.S. equity market, their correlation with U.S. large-cap equities is generally higher than that of international equities.
Correlation in Portfolios
A statistical measure that indicates the degree to which two assets move in relation to each other. Low or negative correlation helps reduce overall portfolio risk.
- Ranges from -1 (perfect negative) to +1 (perfect positive).
- Lower correlation enhances diversification.
- Assets with low correlation tend to move independently.
- Goal is to combine assets that don't all move in the same direction.
Memory trick: Don't put all your eggs in one basket; spread them for safety.