Certified Plan Sponsor Professional (CPSP) Practice Exam

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What is the primary objective of using a diversified portfolio according to modern portfolio theory?

To achieve maximal returns regardless of risk factors.
To minimize overall investment costs.
To reduce risk for any expected level of return by combining negatively correlated assets.
To create a portfolio with the highest possible returns.

The correct answer is: To reduce risk for any expected level of return by combining negatively correlated assets.

The primary objective of using a diversified portfolio, as outlined in modern portfolio theory, is centered around the idea of reducing risk for a given level of expected return by combining assets that are negatively correlated. This means that when one asset performs poorly, another may perform well, which helps to buffer the overall volatility of the portfolio. By strategically selecting a mix of various asset types—such as stocks, bonds, and real estate—that do not move in sync with each other, an investor can construct a portfolio that protects against downturns in the market. This approach acknowledges that while no investment is free of risk, diversification allows an investor to optimize their returns for a given level of risk tolerance. Thus, the correct understanding aligns with modern portfolio theory's emphasis on balancing risk and return through the combination of different assets.