Which One of the Following Statements about Portfolio Diversification Is False?

Explanation

Let's go through each statement and evaluate whether it is true or false:

A. As more securities are added to a portfolio, total risk falls, but at a decreasing rate. This statement is true. Adding more securities to a portfolio can help reduce the overall risk of the portfolio. When securities are combined in a portfolio, their individual risks may be offset by each other, resulting in a reduction of total risk. However, the benefit of diversification diminishes as more securities are added, meaning that the reduction in risk becomes less significant with each additional security.

B. In a well-diversified portfolio of over 25 stocks, market risk will account for over 85% of the portfolio's total risk. This statement is false. In a well-diversified portfolio, the contribution of market risk to the total risk tends to decrease. By holding a diversified portfolio, specific risks associated with individual stocks can be mitigated. Consequently, the proportion of total risk attributable to market risk is expected to decline. It's important to note that the exact percentage may vary depending on various factors, but the general principle is that diversification helps reduce the impact of market risk.

C. The lower the correlation coefficient between the portfolio and a stock, the lower the diversification effect from adding that stock to the portfolio. This statement is false. The correlation coefficient measures the relationship between two variables, in this case, the portfolio and a stock. When the correlation coefficient between the portfolio and a stock is low, it indicates that the price movements of the stock and the portfolio are not strongly correlated. In other words, they tend to move independently of each other. Adding a stock with a low correlation coefficient to a portfolio can enhance diversification because it introduces an asset that has a different risk and return profile. As a result, the diversification effect from adding that stock to the portfolio is higher, not lower.

D. International diversification can further reduce the total risk of a portfolio. This statement is true. International diversification refers to investing in assets from different countries or regions. It can help reduce the total risk of a portfolio by taking advantage of the fact that different markets may behave differently and have low correlations with each other. By including international securities in a portfolio, investors can potentially mitigate risks associated with country-specific events, currency fluctuations, and other factors that may affect domestic investments. Therefore, international diversification has the potential to further reduce the total risk of a portfolio.

In summary, the false statement is: B. In a well-diversified portfolio of over 25 stocks, market risk will account for over 85% of the portfolio's total risk.