Modern Portfolio Theory (MPT)

B is correct. Modern Portfolio Theory emphasizes portfolio-level optimization through diversification across assets with low correlation. Marcus's 70% concentration in a single stock creates severe unsystematic (company-specific) risk that can be eliminated through diversification. By spreading investments across different asset classes (stocks, bonds, real estate) with low correlation, Sarah can reduce portfolio volatility while maintaining or improving expected returns, creating a more efficient portfolio on the risk-return spectrum.

A contradicts MPT's core principle that portfolios should be evaluated holistically, not based on individual security performance. Concentration in one stock exposes Marcus to unnecessary unsystematic risk. C is incorrect because adding correlated stocks in the same industry sector does not provide meaningful diversification; they will move together during sector-specific downturns. D is incorrect because systematic (market) risk CANNOT be eliminated through diversification, only unsystematic risk can. Even a perfectly diversified portfolio retains systematic risk exposure.

B is correct. The fundamental insight of Modern Portfolio Theory is that combining assets with low or negative correlation reduces overall portfolio volatility (risk) below the weighted average of the individual assets. This is the diversification benefit. When one asset declines, low-correlated or negatively-correlated assets may rise or remain stable, smoothing overall portfolio returns and reducing total volatility.

A is incorrect because diversification eliminates only unsystematic (company-specific) risk, not systematic (market) risk. All portfolios retain exposure to systematic risk regardless of diversification. C is incorrect because diversification does not guarantee higher returns; it improves the risk-return trade-off by reducing risk for a given return level or increasing return for a given risk level. D is partially correct but incomplete; MPT shows you can either reduce risk at the same return OR increase return at the same risk level by moving to the efficient frontier, but the primary mechanism is risk reduction through correlation effects.

B is correct. Modern Portfolio Theory evaluates securities based on their contribution to overall PORTFOLIO risk and return, not in isolation. The key MPT principle is that a security's value depends on how it interacts with (correlates with) existing portfolio holdings. Adding a security with low correlation to existing holdings reduces portfolio volatility even if that security itself is volatile. This portfolio-level perspective distinguishes MPT from traditional security analysis.

A contradicts MPT's holistic approach. Individual securities should be evaluated based on their portfolio impact, not standalone characteristics. A high-return security that is highly correlated with existing holdings may increase portfolio risk without proportional return benefit. C represents concentration risk, the opposite of MPT's diversification emphasis. D misunderstands MPT; while systematic risk cannot be eliminated, MPT does not advocate avoiding equities, rather it advocates optimizing the risk-return trade-off through diversification across asset classes.

C is correct (the EXCEPT answer). This statement is FALSE and contradicts MPT. Modern Portfolio Theory specifically recognizes that diversification can eliminate only UNSYSTEMATIC (company-specific) risk, NOT systematic (market) risk. Systematic risk affects all securities and cannot be diversified away. This distinction between diversifiable and non-diversifiable risk is a fundamental component of MPT, not an assumption.

A is accurate: MPT assumes investors are rational and risk-averse, meaning they seek maximum return for a given risk level or minimum risk for a given return level. B is accurate: MPT assumes markets are efficient enough that securities are fairly priced based on available information, making security selection less important than portfolio construction. D is accurate: MPT assumes returns follow a normal distribution, which allows the use of standard deviation as a complete measure of risk. This assumption has been challenged by real-world "fat tails" (extreme events occur more frequently than normal distribution predicts).

C is correct. Statements 1, 3, and 4 are accurate.

Statement 1 is TRUE: The efficient frontier represents the set of optimal portfolios that offer the maximum expected return for each level of risk (or minimum risk for each level of return). Portfolios below the efficient frontier are suboptimal because you could achieve higher returns at the same risk level or lower risk at the same return level by moving to the frontier.

Statement 2 is FALSE: Perfect positive correlation (+1.0) provides NO diversification benefits, not maximum benefits. When two securities move identically together, combining them does not reduce volatility. Maximum diversification benefits come from NEGATIVE correlation (-1.0), where securities move in opposite directions, or at minimum LOW positive correlation (close to 0).

Statement 3 is TRUE: MPT identifies the efficient frontier, but the specific optimal portfolio for each investor depends on where they fall on that frontier based on their risk tolerance. Conservative investors choose lower-risk portfolios on the left side of the frontier, while aggressive investors choose higher-risk, higher-return portfolios on the right side. There is no single "best" portfolio; it varies by individual preference.

Statement 4 is TRUE: This is a core finding of MPT. By diversifying across assets with low or negative correlation, unsystematic (company-specific or sector-specific) risk can be substantially reduced or eliminated. However, systematic (market-wide) risk remains regardless of diversification level.