Diversification
Diversification
The practice of spreading investments across different securities, sectors, or asset classes to reduce unsystematic risk. Does not eliminate systematic (market) risk. Effective diversification requires low or negative correlation between holdings.
A portfolio with 60% stocks (across 8 sectors), 30% bonds, and 10% real estate provides diversification across asset classes and sectors, reducing concentration risk.
Diversification reduces unsystematic (company-specific) risk but cannot eliminate systematic (market) risk. Owning many securities in the same sector does not provide meaningful diversification.
How This Is Tested
- Understanding diversification reduces unsystematic (company-specific) risk but not systematic (market) risk
- Recognizing that effective diversification requires low or negative correlation between holdings
- Identifying proper diversification across sectors, asset classes, and geographies
- Determining when a portfolio lacks diversification despite having many holdings (concentration risk)
- Understanding that over-diversification provides diminishing marginal benefits
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Marcus, age 45, is reviewing his retirement portfolio which currently holds 35 different technology stocks valued at $280,000. He believes his portfolio is well-diversified because he owns so many individual securities. As his investment adviser representative, which recommendation would be most appropriate to improve his portfolio diversification?
B is correct. Marcus's portfolio suffers from concentration risk despite holding 35 securities. All technology stocks are highly correlated and exposed to the same sector risks (regulatory changes, economic cycles, technological disruption). True diversification requires spreading across multiple sectors and asset classes with low correlation to each other.
A is incorrect because adding more technology stocks doesn't reduce sector concentration. they will still move together during tech sector downturns. C is incorrect because the number of holdings alone doesn't ensure diversification; sector and asset class diversity matters more. D is incorrect because reducing holdings increases concentration risk and doesn't address the fundamental lack of sector diversification.
The Series 65 exam tests your ability to distinguish between superficial diversification (many holdings in the same sector) and true diversification (spreading across uncorrelated sectors and asset classes). This is critical for portfolio construction and identifying concentration risk that clients may not recognize.
Which type of risk can be effectively reduced or eliminated through proper portfolio diversification?
C is correct. Diversification effectively reduces or eliminates unsystematic risk. the risk associated with individual companies or sectors. By spreading investments across many uncorrelated securities, company-specific problems (management failures, product recalls, lawsuits) affect only a small portion of the portfolio.
A is incorrect because systematic risk (market risk) affects all securities and cannot be eliminated through diversification. even a perfectly diversified portfolio will decline in a market crash. B is incorrect because inflation risk is a systematic risk that impacts purchasing power across the entire economy. D is incorrect because interest rate risk is a systematic risk affecting all bonds and rate-sensitive securities simultaneously.
The Series 65 exam frequently tests the critical distinction between risks that can be diversified away (unsystematic) and those that cannot (systematic). Understanding this concept is fundamental to portfolio management theory and setting realistic client expectations about what diversification can and cannot achieve.
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Access Free BetaAn investor holds a $500,000 portfolio with the following allocations: 40% in one pharmaceutical stock ($200,000), 30% in healthcare mutual fund ($150,000), 20% in biotech ETF ($100,000), and 10% in money market ($50,000). What percentage of this portfolio is concentrated in the healthcare sector?
C is correct. Calculate total healthcare exposure: pharmaceutical stock (40%) + healthcare mutual fund (30%) + biotech ETF (20%) = 90% in healthcare sector. The money market (10%) is the only non-healthcare holding. This demonstrates severe concentration risk despite appearing diversified across different investment types.
A (40%) incorrectly counts only the individual pharmaceutical stock and misses that the mutual fund and ETF are also healthcare sector investments. B (70%) incorrectly excludes the biotech ETF from healthcare sector. D (100%) incorrectly includes the money market funds, which are cash equivalents, not healthcare investments.
The Series 65 exam tests your ability to identify hidden concentration risk when clients hold multiple investment vehicles (individual stocks, mutual funds, ETFs) that all invest in the same sector. You must analyze total sector exposure across all account holdings, not just individual positions, to properly assess diversification.
All of the following statements about portfolio diversification are accurate EXCEPT
C is correct (the EXCEPT answer). This statement is FALSE. Diversification can reduce or eliminate unsystematic (company-specific) risk but CANNOT eliminate systematic (market) risk. Even a perfectly diversified portfolio will decline when the overall market falls. this is a fundamental principle of Modern Portfolio Theory.
A is accurate: diversification specifically targets unsystematic risk by ensuring that individual security problems don't significantly impact the entire portfolio. B is accurate: correlation is key to diversification. assets that move together (high correlation) don't provide meaningful diversification benefits. D is accurate: true diversification spreads across multiple dimensions (sectors, asset classes, geographies), not just number of holdings.
The Series 65 exam tests whether you understand the fundamental limitation of diversification. it cannot protect against market-wide downturns. This is critical for setting proper client expectations and explaining why even diversified portfolios experience losses during market corrections. Investment advisers must accurately represent what diversification can and cannot accomplish.
An investment adviser is analyzing a client's portfolio consisting of 20 large-cap U.S. growth stocks, all in the technology sector. Which of the following risks does this portfolio face?
1. Concentration risk from sector exposure
2. Currency risk from international holdings
3. Correlation risk from similar holdings moving together
4. Unsystematic risk from individual company failures
C is correct. Statements 1, 3, and 4 are accurate.
Statement 1 is TRUE: The portfolio has severe concentration risk with 100% allocation to a single sector (technology). Sector-specific events (regulatory changes, technological disruption, economic cycles) will impact all holdings simultaneously.
Statement 2 is FALSE: Currency risk does not apply because the portfolio holds only U.S. stocks denominated in dollars. Currency risk would exist if the portfolio held international securities or ADRs with foreign exchange exposure.
Statement 3 is TRUE: Technology stocks are highly correlated. they tend to move together based on sector trends, interest rate changes, and growth stock valuations. This high correlation means the portfolio lacks meaningful diversification despite having 20 different holdings.
Statement 4 is TRUE: The portfolio still faces unsystematic risk from individual company events (earnings misses, management changes, product failures). While diversification across 20 stocks reduces this risk compared to owning just one, sector concentration prevents full unsystematic risk elimination.
The Series 65 exam tests your ability to identify multiple risk types simultaneously and understand how they interact. This question demonstrates that a portfolio can have many holdings yet still suffer from concentration risk, high correlation, and inadequate diversification. Advisers must recognize these overlapping risk exposures to make appropriate portfolio recommendations.
💡 Memory Aid
Think of diversification like having friends in different cities: If San Francisco has an earthquake (COMPANY risk), your NYC friends are fine. But a global pandemic (MARKET risk) hits everyone everywhere. True diversification needs friends who react DIFFERENTLY to the same news (low correlation).
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Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: