Which theory emphasizes diversification to optimize risk and return in an investment portfolio?

Which theory emphasizes diversification to optimize risk and return in an investment portfolio?

• A. Efficient Market Hypothesis
• B. Random-Waltz Theory
• C. Modern Portfolio Theory
• D. Odd-1st Ratio

Answer: (C)

Diversification to balance risk and return is what is being tested here. Modern Portfolio Theory, developed by Harry Markowitz, shows you can lower risk by mixing assets that don’t move together perfectly. When asset returns aren’t perfectly correlated, the portfolio’s overall volatility can be smaller than the weighted average of the individual volatilities. The aim is to maximize expected return for a given level of risk (or minimize risk for a given return), which traces out the efficient frontier of optimally diversified portfolios. The theory also recognizes that some risk (systematic risk) cannot be eliminated, but unsystematic risk can be reduced through diversification. In essence, diversification is the main tool for optimizing the risk–return trade-off.

Diversification to balance risk and return is what is being tested here. Modern Portfolio Theory, developed by Harry Markowitz, shows you can lower risk by mixing assets that don’t move together perfectly. When asset returns aren’t perfectly correlated, the portfolio’s overall volatility can be smaller than the weighted average of the individual volatilities. The aim is to maximize expected return for a given level of risk (or minimize risk for a given return), which traces out the efficient frontier of optimally diversified portfolios. The theory also recognizes that some risk (systematic risk) cannot be eliminated, but unsystematic risk can be reduced through diversification. In essence, diversification is the main tool for optimizing the risk–return trade-off.