Modern portfolio theory advises investors to consider what kind of asset correlation?

Modern portfolio theory advises investors to consider what kind of asset correlation?

• A. Perfectly correlated
• B. Lesser than perfect correlation
• C. Highly correlated
• D. No correlation

Answer: (B)

Modern portfolio theory emphasizes the importance of diversifying investments to optimize returns while minimizing risk. One of the key concepts within this theory is the relationship between asset correlations. When assets are less than perfectly correlated, it means that they do not move in the same direction or by the same magnitude in response to market events. This is beneficial for constructing a portfolio. When an investor combines assets with a lesser than perfect correlation, the overall portfolio volatility can be reduced. For example, if one asset is performing poorly while another is performing well, the losses in the poor-performing asset can be offset by gains in the better-performing asset. This reduces the overall risk associated with the portfolio. In contrast, perfectly correlated assets would move in tandem, which offers no diversification benefit. Similarly, highly correlated assets would also not significantly reduce risk, as they tend to react similarly to market changes. Assets with no correlation can offer some diversification benefits, but achieving a well-structured portfolio with lesser than perfect correlation is the ideal scenario to maximize the risk-return trade-off recommended by modern portfolio theory.

Modern portfolio theory emphasizes the importance of diversifying investments to optimize returns while minimizing risk. One of the key concepts within this theory is the relationship between asset correlations. When assets are less than perfectly correlated, it means that they do not move in the same direction or by the same magnitude in response to market events. This is beneficial for constructing a portfolio.

When an investor combines assets with a lesser than perfect correlation, the overall portfolio volatility can be reduced. For example, if one asset is performing poorly while another is performing well, the losses in the poor-performing asset can be offset by gains in the better-performing asset. This reduces the overall risk associated with the portfolio.

In contrast, perfectly correlated assets would move in tandem, which offers no diversification benefit. Similarly, highly correlated assets would also not significantly reduce risk, as they tend to react similarly to market changes. Assets with no correlation can offer some diversification benefits, but achieving a well-structured portfolio with lesser than perfect correlation is the ideal scenario to maximize the risk-return trade-off recommended by modern portfolio theory.