Chapter 6 - Portfolio Construction and Planning

Question 1

Which of the following is the primary factor influencing portfolio construction?

A) Market timing
B) Investor’s tax liability
C) Investment objective
D) Performance of specific asset classes

Answer 1

✅ Answer: C) Investment objective

📌 Explanation: Portfolio construction starts with defining the investor’s goals, risk tolerance, and time horizon. Market timing and tax liabilities are secondary considerations.

Question 2

How does a longer investment horizon typically impact portfolio risk?

A) It increases the risk due to economic uncertainty
B) It reduces risk as short-term volatility has less impact
C) It has no impact on risk levels
D) It makes short-term investments more attractive

Answer 2

✅ Answer: B) It reduces risk as short-term volatility has less impact

📌 Explanation: Longer time horizons allow investors to weather market fluctuations, meaning they can take on more risk for higher potential returns.

Question 3

What is the key difference between ‘attitude to risk’ and ‘capacity for loss’?

A) Attitude to risk is objective, while capacity for loss is subjective
B) Attitude to risk is an emotional response, whereas capacity for loss is a financial measure
C) Both are measured using quantitative models
D) Attitude to risk is more important than capacity for loss

Answer 3

✅ Answer: B) Attitude to risk is an emotional response, whereas capacity for loss is a financial measure

📌 Explanation: Attitude to risk is how comfortable an investor is with losses, while capacity for loss refers to their ability to withstand financial losses without affecting their lifestyle.

Question 4

What is the main role of asset allocation in portfolio construction?

A) To maximize tax efficiency
B) To minimize transaction costs
C) To balance risk and return
D) To eliminate risk completely

Answer 4

✅ Answer: C) To balance risk and return

📌 Explanation: Asset allocation is the process of diversifying investments across asset classes to achieve an optimal balance of risk and return.

Question 5

Which of the following is an example of a stochastic model in portfolio planning?

A) Using historical average returns to predict future performance
B) Monte Carlo simulations
C) Linear regression of past data
D) A buy-and-hold strategy

Answer 5

✅ Answer: B) Monte Carlo simulations

📌 Explanation: Stochastic models (like Monte Carlo simulations) use random probability distributions to simulate different market conditions.

Question 6

How does a deterministic model differ from a stochastic model?

A) Deterministic models use historical volatility, while stochastic models do not
B) Deterministic models provide a single outcome, while stochastic models simulate multiple scenarios
C) Stochastic models are used only in active management
D) Stochastic models assume fixed rates of return

Answer 6

✅ Answer: B) Deterministic models provide a single outcome, while stochastic models simulate multiple scenarios

📌 Explanation: Deterministic models assume fixed inputs and generate a single projected outcome, while stochastic models incorporate randomness to simulate multiple possibilities.

Question 7

Which investment strategy involves selecting securities to outperform a benchmark?

A) Passive management
B) Strategic asset allocation
C) Active management
D) Dollar-cost averaging

Answer 7

✅ Answer: C) Active management

📌 Explanation: Active management involves buying and selling assets to outperform a benchmark, unlike passive management, which follows a set index.

Question 8

What is a key characteristic of Strategic Asset Allocation (SAA)?

A) Frequent rebalancing based on market movements
B) Adjusting investments dynamically based on economic conditions
C) A long-term approach with fixed target allocations
D) Choosing individual stocks with high growth potential

Answer 8

✅ Answer: C) A long-term approach with fixed target allocations

📌 Explanation: SAA sets a fixed proportion of assets in a portfolio and only rebalances periodically to maintain the chosen allocation.

Question 9

Tactical Asset Allocation (TAA) is best described as:

A) A long-term buy-and-hold strategy
B) Short-term adjustments to take advantage of market conditions
C) A fixed percentage allocation to asset classes
D) An approach that only considers risk but not return

Answer 9

✅ Answer: B) Short-term adjustments to take advantage of market conditions

📌 Explanation: TAA makes short-term deviations from a portfolio’s strategic allocation to capitalize on market trends.

Question 10

Which risk measure is most relevant when constructing a portfolio for a risk-averse investor?

A) Sharpe ratio
B) Beta
C) Value at Risk (VaR)
D) Standard deviation

Answer 10

✅ Answer: C) Value at Risk (VaR)

📌 Explanation: VaR estimates potential portfolio losses in a worst-case scenario, making it useful for risk-averse investors.

Question 11

What does the Sharpe ratio measure?

A) The level of diversification in a portfolio
B) Risk-adjusted return
C) The correlation between asset classes
D) Portfolio volatility

Answer 11

✅ Answer: B) Risk-adjusted return

📌 Explanation: Sharpe ratio measures how much excess return an investment earns per unit of risk taken.

Question 12

Why might a fund manager use passive management?

A) To increase turnover and generate commissions
B) To avoid stock selection risk
C) To outperform the market consistently
D) To reduce exposure to systematic risk

Answer 12

✅ Answer: B) To avoid stock selection risk

📌 Explanation: Passive management tracks an index to reduce the risk of picking the wrong stocks.

Question 13

Which asset class typically offers the highest long-term return?

A) Cash
B) Bonds
C) Equities
D) Commodities

Answer 13

✅ Answer: C) Equities

📌 Explanation: Historically, equities have provided higher returns than bonds and cash, but with greater volatility.

Question 14

What is a major limitation of Monte Carlo simulations in portfolio modeling?

A) It cannot account for extreme market events
B) It assumes perfect market efficiency
C) It is only useful for short-term forecasting
D) It ignores correlations between asset classes

Answer 14

✅ Answer: A) It cannot account for extreme market events

📌 Explanation: Monte Carlo simulations are based on historical data and may underestimate black swan events like financial crises.

Question 15

15. What is the key difference between SAA and TAA?

A) SAA is based on risk tolerance, while TAA is based on tax efficiency
B) SAA remains fixed over time, while TAA makes adjustments based on market conditions
C) SAA is for short-term investors, while TAA is for long-term investors
D) SAA focuses on market trends, while TAA follows a fixed index

Answer 15

✅ Answer: B) SAA remains fixed over time, while TAA makes adjustments based on market conditions

📌 Explanation: SAA follows a long-term strategy, while TAA actively shifts asset allocation to take advantage of market conditions.

Question 16

What is a common problem with purely passive portfolios?

A) They have lower fees
B) They are not well-diversified
C) They underperform active portfolios
D) They do not react to market conditions

Answer 16

✅ Answer: D) They do not react to market conditions

📌 Explanation: Passive portfolios do not adjust for economic changes, which can be a disadvantage in volatile markets.

Question 17

What is a key drawback of using historical data for asset allocation modeling?

A) It assumes future performance will be identical to past trends
B) It does not account for correlations between asset classes
C) It only applies to active management strategies
D) It increases diversification risk

Answer 17

✅ Answer: A) It assumes future performance will be identical to past trends

📌 Explanation: Historical data is useful for modeling, but it does not guarantee future results. Market conditions, correlations, and economic cycles change over time, making it unreliable as the sole input for asset allocation.

Question 18

Which of the following is a key challenge in Tactical Asset Allocation (TAA)?

A) It requires high transaction costs and market timing skills
B) It does not allow any deviation from strategic allocation
C) It is only suitable for long-term investors
D) It eliminates all portfolio risk

Answer 18

✅ Answer: A) It requires high transaction costs and market timing skills

📌 Explanation: TAA involves frequent adjustments to asset allocations to capitalize on short-term opportunities. This increases transaction costs and requires accurate market timing, which is difficult to execute consistently.

Question 19

Which of the following best describes the concept of ‘risk-adjusted return’?

A) A measure of the return generated per unit of risk taken
B) The total expected return of a portfolio over a time period
C) The absolute return generated by a security regardless of risk
D) A measure used only in passive investing strategies

Answer 19

✅ Answer: A) A measure of the return generated per unit of risk taken

📌 Explanation: Risk-adjusted return helps investors compare investments with different risk levels. Ratios like the Sharpe ratio and Sortino ratio measure how much return is generated per unit of risk.

Question 19

When assessing a client’s risk tolerance, why is behavioral finance important?

A) It helps identify biases that may lead to suboptimal investment decisions
B) It focuses solely on quantitative financial measures
C) It eliminates all subjectivity from the risk assessment process
D) It replaces the need for traditional financial planning

Answer 19

✅ Answer: A) It helps identify biases that may lead to suboptimal investment decisions

📌 Explanation: Behavioral finance helps advisors understand psychological biases, such as loss aversion or overconfidence, which can impact decision-making and risk assessment.

Question 20

According to the Efficient Market Hypothesis (EMH), which of the following statements is TRUE?

A) Investors can consistently achieve above-average returns by analyzing historical price data
B) Stock prices reflect all available information at any given time
C) Markets are always inefficient due to behavioral biases
D) Passive investing is unlikely to match market returns over time

Answer 20

✅ Answer: B) Stock prices reflect all available information at any given time

📌 Explanation: The EMH states that stock prices incorporate all available information, making it difficult for investors to consistently outperform the market. This supports passive investing and questions the long-term success of active management.

Question 21

Which form of the EMH suggests that even insider information is already reflected in stock prices?

A) Weak form
B) Semi-strong form
C) Strong form
D) Fundamental form

Answer 21

✅ Answer: C) Strong form

📌 Explanation: The strong form of EMH suggests that stock prices reflect all public and private (insider) information, making it impossible for any investor, including insiders, to gain a consistent advantage.

Question 22

What is the primary assumption behind Modern Portfolio Theory (MPT)?

A) Investors prefer portfolios that maximize return for a given level of risk
B) Investors always make irrational decisions
C) Stocks with lower volatility always provide higher returns
D) Market timing is the key to maximizing portfolio returns

Answer 22

✅ Answer: A) Investors prefer portfolios that maximize return for a given level of risk

📌 Explanation: MPT, developed by Harry Markowitz, assumes investors are risk-averse and seek to optimize returns for a given level of risk by diversifying across asset classes.

Question 23

Which of the following asset classes historically has the lowest correlation with equities?

A) Corporate bonds
B) Government bonds
C) Commodities
D) Small-cap stocks

Answer 23

✅ Answer: C) Commodities

📌 Explanation: Commodities often have a low or negative correlation with equities, making them an effective diversification tool in portfolio construction.

Question 23

What does the Capital Asset Pricing Model (CAPM) primarily attempt to measure? A) The total risk of a security B) The risk-free rate of return C) The expected return based on systematic risk D) The correlation between different asset classes

Answer 23

✅ Answer: C) The expected return based on systematic risk 📌 Explanation: CAPM estimates the expected return of an asset based on systematic risk (beta), the risk-free rate, and the equity risk premium.

Question 24

What does a correlation coefficient of +1 between two asset classes indicate? A) The asset classes move in opposite directions B) The asset classes move independently of each other C) The asset classes move in perfect unison D) One asset class is riskier than the other

Answer 24

✅ Answer: C) The asset classes move in perfect unison 📌 Explanation: A correlation of +1 means two asset classes always move together, providing no diversification benefit.

Question 25

Which of the following is a key limitation of using historical asset class returns for portfolio construction? A) Historical returns always predict future performance B) Correlations between asset classes remain constant over time C) Past performance does not guarantee future results D) Volatility does not impact portfolio returns

Answer 25

✅ Answer: C) Past performance does not guarantee future results 📌 Explanation: Historical returns are useful for analysis, but market conditions change, making past performance an imperfect predictor of the future.

Question 26

In CAPM, what does beta measure? A) The total risk of an investment B) The systematic risk relative to the market C) The expected dividend yield D) The risk-free rate

Answer 26

✅ Answer: B) The systematic risk relative to the market 📌 Explanation: Beta measures an asset's sensitivity to market movements. A beta of 1 means the asset moves in line with the market, while a beta of greater than 1 means higher volatility.

Question 27

What is a major drawback of using diversification as a risk management strategy? A) It increases transaction costs B) It eliminates systematic risk C) It reduces expected returns D) It ensures market outperformance

Answer 27

✅ Answer: A) It increases transaction costs 📌 Explanation: Diversification reduces unsystematic risk, but managing multiple assets leads to higher costs, especially with frequent rebalancing.

Question 28

Which investment approach relies on factors like momentum, value, and size to construct portfolios? A) Passive investing B) Factor investing C) Strategic asset allocation D) Tactical asset allocation

Answer 28

✅ Answer: B) Factor investing 📌 Explanation: Factor investing selects securities based on characteristics such as momentum, size, value, and volatility, rather than broad market exposure.

Question 29

What is a key assumption of the efficient frontier in MPT? A) Investors are indifferent to risk B) All investors have the same risk tolerance C) Higher risk leads to higher potential returns D) Markets are always predictable

Answer 29

✅ Answer: C) Higher risk leads to higher potential returns 📌 Explanation: The efficient frontier illustrates portfolios that maximize return for a given level of risk, reinforcing the risk-return tradeoff.

Question 30

Which of the following statements about asset correlation is TRUE? A) A correlation of 0 means assets move in opposite directions B) Correlations between assets can change over time C) Higher correlation always improves diversification D) Bonds and equities always have negative correlation

Answer 30

✅ Answer: B) Correlations between assets can change over time 📌 Explanation: Correlations are not static and can shift depending on economic conditions, interest rates, and market sentiment.

Question 31

Which type of diversification is used to reduce company-specific risk? A) Market timing B) Asset allocation C) Sector diversification D) Currency hedging

Answer 31

✅ Answer: C) Sector diversification 📌 Explanation: Investing across different sectors reduces exposure to company-specific risks

Question 32

In CAPM, what does the market risk premium represent? A) The difference between a risk-free return and a risky asset’s return B) The additional return expected for taking on market risk C) The cost of investing in government bonds D) The total return of the stock market

Answer 32

✅ Answer: B) The additional return expected for taking on market risk 📌 Explanation: The market risk premium is the return investors expect above the risk-free rate as compensation for market volatility.

Question 33

What is the primary advantage of using stochastic modeling over deterministic modeling? A) It allows for a single, fixed outcome B) It incorporates randomness and multiple scenarios C) It assumes markets are always rational D) It ignores historical market data

Answer 33

✅ Answer: B) It incorporates randomness and multiple scenarios 📌 Explanation: Stochastic modeling considers multiple possible future outcomes, making it more realistic than deterministic models.

Question 34

Which of the following is NOT a limitation of using historical data for portfolio construction? A) Correlations between asset classes may change over time B) Past performance does not guarantee future returns C) Historical risk and return metrics are always accurate predictors D) Historical data is unaffected by economic cycles

Answer 34

✅ Answer: D) Historical data is unaffected by economic cycles 📌 Explanation: Historical data is highly influenced by economic cycles, market conditions, and investor sentiment. Assuming past trends will always persist is a major limitation in portfolio construction.

Question 35

A portfolio consisting of two uncorrelated assets will exhibit which characteristic? A) Higher risk than either individual asset B) Lower volatility than the weighted average of its components C) A beta of 1 D) A correlation of exactly -1

Answer 35

✅ Answer: B) Lower volatility than the weighted average of its components 📌 Explanation: When two assets are uncorrelated, their price movements are independent. This provides diversification benefits, reducing overall portfolio volatility.

Question 36

Which of the following statements about Tactical Asset Allocation (TAA) is TRUE? A) It involves frequent adjustments based on short-term market conditions B) It is a purely passive investment strategy C) It assumes that asset correlations remain constant D) It has lower transaction costs than Strategic Asset Allocation (SAA)

Answer 36

✅ Answer: A) It involves frequent adjustments based on short-term market conditions 📌 Explanation: TAA aims to exploit short-term market inefficiencies by adjusting asset allocation more frequently than SAA, often resulting in higher transaction costs.

Question 37

If an investor constructs a portfolio using the Black-Litterman model, which key factor is being incorporated? A) Mean-variance optimization without constraints B) Investor-specific market views alongside historical data C) The assumption that asset returns are normally distributed D) A static allocation that does not require rebalancing

Answer 37

✅ Answer: B) Investor-specific market views alongside historical data 📌 Explanation: The Black-Litterman model enhances Modern Portfolio Theory by incorporating investor views alongside historical return and risk data to create a more customized and balanced portfolio.

Question 38

If a portfolio’s Sharpe ratio increases after adding an asset with lower expected return than the portfolio, what does this indicate? A) The asset has a higher standard deviation than the portfolio B) The asset has a correlation coefficient of 1 with the portfolio C) The asset provides diversification benefits, improving risk-adjusted returns D) The asset reduces overall portfolio returns without affecting volatility

Answer 38

✅ Answer: C) The asset provides diversification benefits, improving risk-adjusted returns 📌 Explanation: The Sharpe ratio measures risk-adjusted returns. If adding an asset increases the ratio, it means the asset reduces risk more than it reduces return, enhancing overall portfolio efficiency.

Question 39

Which of the following best describes the impact of a high Reduction in Yield (RIY) on an investment portfolio? A) It increases total returns over time B) It reduces the net return an investor receives C) It has no impact if the fund performs well D) It only applies to actively managed funds

Answer 39

✅ Answer: B) It reduces the net return an investor receives 📌 Explanation: RIY measures how much the total costs of an investment reduce the overall return. A higher RIY means lower net returns, as more is deducted in fees and charges.

Question 39

Which of the following would be considered a qualitative factor in fundamental analysis? A) The company’s Price-to-Earnings (P/E) ratio B) The CEO’s track record and leadership style C) The company’s Earnings Per Share (EPS) growth D) The firm’s debt-to-equity ratio

Answer 39

✅ Answer: B) The CEO’s track record and leadership style 📌 Explanation: Fundamental analysis includes qualitative factors (management quality, brand strength) and quantitative factors (financial ratios, earnings growth). Leadership ability is qualitative.

Question 39

What does the Total Expense Ratio (TER) include that the Ongoing Charges Figure (OCF) does NOT? A) Trading costs within the fund B) Management fees C) Entry and exit fees D) Performance fees

Answer 39

✅ Answer: D) Performance fees 📌 Explanation: TER includes all ongoing charges plus performance fees, whereas OCF only considers regular ongoing charges such as management fees and administration costs.

Question 40

Which investment analysis method is based on identifying historical price patterns? A) Fundamental analysis B) Quantitative analysis C) Technical analysis D) Credit analysis

Answer 40

✅ Answer: C) Technical analysis 📌 Explanation: Technical analysis studies past price movements and chart patterns to predict future price changes, unlike fundamental analysis, which focuses on company financials.

Question 40

When selecting an investment provider, which of the following is LEAST relevant? A) The provider's financial strength and credit rating B) The provider’s range of investment products C) The provider’s ability to offer guaranteed market returns D) The provider’s regulatory compliance history

Answer 40

✅ Answer: C) The provider’s ability to offer guaranteed market returns 📌 Explanation: No provider can guarantee returns in an uncertain market. Financial strength, product range, and compliance history are far more relevant factors when selecting an investment provider.

Question 41

What is a key advantage of using a wrap platform for investments? A) It provides higher investment returns B) It allows investors to hold multiple assets in a single account C) It eliminates all investment costs D) It is only available to institutional investors

Answer 41

✅ Answer: B) It allows investors to hold multiple assets in a single account 📌 Explanation: Wrap platforms enable consolidation of different asset classes (funds, bonds, shares) within one account, improving efficiency and transparency for investors.

Question 42

Which factor is typically NOT considered when conducting fund analysis? A) The fund manager’s historical performance B) The fund’s sector allocation C) The number of transactions in the fund’s history D) The fund’s Sharpe ratio

Answer 42

✅ Answer: C) The number of transactions in the fund’s history 📌 Explanation: While turnover ratios are sometimes considered, the total number of transactions alone is not a key indicator in fund analysis.

Question 43

Which of the following best describes sector-specific reports? A) Reports analyzing trends and valuations in a particular industry B) Reports focusing exclusively on macroeconomic trends C) Reports comparing performance of fund managers D) Reports tracking insider trading activity

Answer 43

✅ Answer: A) Reports analyzing trends and valuations in a particular industry 📌 Explanation: Sector-specific reports focus on industry trends, regulations, and valuations, helping investors assess risks and opportunities in specific markets.

Question 43

A high Ongoing Charges Figure (OCF) is most likely to negatively impact which type of investment? A) An actively managed equity fund B) A passive index-tracking fund C) A hedge fund with performance-based fees D) A structured product with capital protection

Answer 43

✅ Answer: B) A passive index-tracking fund 📌 Explanation: Passive funds typically have low costs, so a high OCF would disproportionately reduce returns compared to an actively managed fund.

Question 44

What is a potential drawback of broker and distribution reports? A) They always provide biased recommendations B) They focus only on short-term price movements C) They rely on unverified data sources D) They can be influenced by conflicts of interest

Answer 44

✅ Answer: D) They can be influenced by conflicts of interest 📌 Explanation: Brokers often earn commissions from specific investment products, which can introduce bias in their recommendations.

Question 45

What is the primary objective of deterministic modeling in investment planning? A) To factor in a range of possible future outcomes B) To provide a single expected return outcome C) To apply Monte Carlo simulations D) To adjust allocations dynamically based on market conditions

Answer 45

✅ Answer: B) To provide a single expected return outcome 📌 Explanation: Deterministic models provide a fixed return assumption, whereas stochastic models account for uncertainty and variability.

Question 46

What is a key feature of a passive investment management approach? A) Frequent portfolio rebalancing B) Market timing strategies C) Low-cost index replication D) Investing only in high-growth stocks

Answer 46

✅ Answer: C) Low-cost index replication 📌 Explanation: Passive management aims to replicate an index, minimizing costs and avoiding active trading.

Question 47

What does a high Sharpe ratio indicate? A) High absolute returns B) Good risk-adjusted returns C) Low volatility D) Low correlation with the market

Answer 47

✅ Answer: B) Good risk-adjusted returns 📌 Explanation: The Sharpe ratio measures returns per unit of risk. A higher ratio means better risk-adjusted performance.

Question 48

What does the term "alpha" refer to in fund performance? A) The fund’s absolute return B) Excess return over a benchmark after adjusting for risk C) The volatility of the fund’s returns D) The correlation between the fund and the market

Answer 48

✅ Answer: B) Excess return over a benchmark after adjusting for risk 📌 Explanation: Alpha represents the extra return generated beyond the market benchmark, adjusting for risk.

Question 49

A fund with high turnover is most likely to have which characteristic? A) Lower transaction costs B) Lower tax efficiency C) Lower capital gains distributions D) Less active management

Answer 49

✅ Answer: B) Lower tax efficiency 📌 Explanation: High turnover leads to more taxable events, reducing tax efficiency.

Question 50

What is the key distinction between the Total Expense Ratio (TER) and the Ongoing Charges Figure (OCF)? A) The TER includes trading costs, while the OCF does not B) The OCF includes entry and exit fees, whereas the TER does not C) The TER is always higher than the OCF for the same fund D) The OCF is a more recent and standardized measure of ongoing fund costs

Answer 50

✅ Answer: D) The OCF is a more recent and standardized measure of ongoing fund costs 📌 Explanation: The OCF replaced the TER as a standardized measure of fund charges, focusing solely on ongoing costs. The TER often included additional expenses like performance fees, which the OCF does not.

Question 51

Why might a value investor favor fundamental analysis over technical analysis? A) Technical analysis does not account for financial statements or intrinsic value B) Fundamental analysis relies solely on historical price trends C) Value investing is based on short-term market sentiment D) Fundamental analysis is primarily used for speculative trading

Answer 51

✅ Answer: A) Technical analysis does not account for financial statements or intrinsic value 📌 Explanation: Value investors seek undervalued stocks by analyzing financial statements, earnings, and company fundamentals. Technical analysis, on the other hand, focuses on price movements and charts, which do not indicate a stock's true intrinsic value.

Question 52

How do sector-specific reports assist in stock selection? A) They identify market inefficiencies that traders can arbitrage B) They provide in-depth analysis of industry-wide risks and opportunities C) They focus exclusively on past performance trends in a sector D) They allow investors to time the market based on economic cycles

Answer 52

✅ Answer: B) They provide in-depth analysis of industry-wide risks and opportunities 📌 Explanation: Sector-specific reports offer detailed insights into industry trends, risks, and growth potential, allowing investors to make informed stock selection decisions based on sector strength and future outlooks.

Question 53

What are the risks of using Monte Carlo simulations for investment forecasting? A) Monte Carlo simulations can predict market crashes accurately B) The accuracy of Monte Carlo results depends on input assumptions C) Monte Carlo models eliminate all investment risk D) Simulations assume that historical correlations remain constant

Answer 53

✅ Answer: B) The accuracy of Monte Carlo results depends on input assumptions 📌 Explanation: Monte Carlo simulations rely on assumptions about risk, return, and volatility. If these assumptions are flawed or unrealistic, the output will be misleading, making the forecast unreliable.

Question 53

Why is correlation an important factor in asset allocation? A) A high correlation between assets ensures a well-diversified portfolio B) Correlation measures an asset’s expected return C) Low correlation between asset classes reduces overall portfolio risk D) Correlation is only relevant for passive investing strategies

Answer 53

✅ Answer: C) Low correlation between asset classes reduces overall portfolio risk 📌 Explanation: Diversification works best when assets have low or negative correlation, as this ensures that when one asset class declines, another may remain stable or rise, thus reducing overall portfolio volatility.