Certified Plan Sponsor Professional (CPSP) Practice Exam

According to modern portfolio theory, which portfolio is considered diversified?

1. A portfolio invested entirely in stocks.

2. A portfolio invested equally in stocks, bonds, and cash.

3. A portfolio that includes only real estate investments.

4. A portfolio heavily weighted in bonds.

The correct answer is: A portfolio invested equally in stocks, bonds, and cash.

Diversification, as outlined by modern portfolio theory, refers to the practice of spreading investments across various asset classes to reduce risk. This approach aims to minimize the impact of any single investment's poor performance on the overall portfolio. The choice of a portfolio invested equally in stocks, bonds, and cash exemplifies diversification because it includes multiple asset classes that typically respond differently to market conditions. Stocks might perform well when the economy is booming, while bonds can provide stability in periods of downturns. Cash serves as a liquid reserve that can stabilize a portfolio and provide flexibility for investment opportunities. In contrast, a portfolio invested entirely in stocks lacks this balance and is therefore more vulnerable to market volatility. Similarly, a portfolio focused solely on real estate investments or one heavily weighted in bonds can face specific risks related to those asset types. For instance, real estate can be affected by market fluctuations, while a bond-heavy portfolio might underperform in a rising interest rate environment. Thus, a portfolio that combines stocks, bonds, and cash demonstrates an effective diversification strategy, aligning with the principles of modern portfolio theory.