Certified Plan Sponsor Professional (CPSP) Practice Exam

What does modern portfolio theory seek to achieve by investing assets?

1. Maximize returns without regard to risk.

2. Minimize risk for any projected level of return by investing in a diversified portfolio.

3. Eliminate risk entirely in investments.

4. Focus exclusively on short-term gains.

The correct answer is: Minimize risk for any projected level of return by investing in a diversified portfolio.

Modern portfolio theory emphasizes the importance of diversification in investment portfolios to achieve a balance between risk and return. The theory postulates that by combining a variety of assets that have differing levels of risk and returns, an investor can minimize the overall risk while still achieving a desired level of expected return. This strategy helps in optimizing the portfolio, ensuring that the potential returns are maximized for a given level of risk, or alternatively, minimizing risk for a desired return level. This concept operates under the premise that not all investments react similarly to market movements, and by strategically selecting a mix of asset types—including stocks, bonds, and other investment vehicles—investors can protect their portfolios from the inherent volatility of individual assets. Thus, by diversifying investments, modern portfolio theory seeks to lower the risk in the portfolio without sacrificing potential returns, leading to a more efficient investment strategy overall.