Asset Allocation

A new rule sharply raises compliance costs for airlines and for no other industry. An investor holds airlines alongside positions in twelve other industries. How should the exposure be classified?

1. A.Systematic, because a change in government policy is by nature market-wide.Wrong. Policy changes can be narrow, and this one leaves twelve other industries entirely untouched.
2. B.Nonsystematic, because spreading across industries limits the damage it can do.Correct. An exposure confined to one industry is diluted by holdings elsewhere, which is what makes it diversifiable.
3. C.Systematic, because every airline in the portfolio is affected at the same time.Wrong. Simultaneity within a group is not the test; the test is whether holdings outside that group escape it.
4. D.Nonsystematic, because compliance costs are an operating matter rather than a market one.Wrong. The conclusion is right but the reasoning is not, since an economy-wide cost increase would be systematic.

Why: The line between systematic and nonsystematic runs on whether an exposure can be diluted by holding other things. A rule reaching one industry hurts that slice of the portfolio while the twelve other industries carry on, so the overall impact is limited by the size of the airline allocation. That makes it nonsystematic even though it strikes many companies at the same moment. Had the rule raised costs across the whole economy, no allocation choice would have escaped it and the classification would flip.

A client's target allocation is 60 percent stocks and 40 percent bonds. After a strong equity year the actual mix stands at 72 and 28. What does rebalancing accomplish?

1. A.It raises expected return by concentrating in whichever asset has performed best.Wrong. Rebalancing does the opposite, trimming the winners rather than concentrating further in them.
2. B.It eliminates the portfolio's exposure to broad market declines going forward.Wrong. Any equity allocation leaves market risk in place, and rebalancing sets its size rather than its existence.
3. C.It sells part of what has risen and restores the intended level of risk.Correct. Drift has lifted equity exposure above target, and selling back to target restores the chosen risk level.
4. D.It converts systematic risk into nonsystematic risk that can then be diversified.Wrong. The two categories are not interchangeable, and no trade converts one of them into the other.

Why: An allocation is a statement about how much risk the investor intends to carry, and market movements steadily push the actual mix away from it. After a strong equity year the portfolio holds more stock than intended, so it carries more systematic risk than the plan called for. Rebalancing sells the appreciated asset and buys the lagging one, returning the mix, and with it the risk, to target. The point is discipline about risk rather than a prediction that the winning asset is about to fall.

A client holds 40 stocks spread across every major sector and asks how to reduce risk further. Which change would most meaningfully lower the portfolio's total volatility?

1. A.Adding another 40 stocks drawn from the same set of sectors.Wrong. Issuer-specific risk is already nearly eliminated at 40 names, so more of the same adds almost nothing.
2. B.Replacing the highest-priced holdings with lower-priced shares.Wrong. Share price reflects how the equity is divided into units and says nothing about volatility.
3. C.Allocating part of the portfolio to high-quality bonds.Correct. Adding an asset class that does not move with equities lowers the portfolio's overall market exposure.
4. D.Concentrating the portfolio in the sectors that have been most stable.Wrong. Concentrating in fewer sectors reintroduces exactly the industry risk the client has already diversified away.

Why: Once a portfolio holds several dozen securities spread across sectors, nearly all the issuer-specific risk is gone and what remains is systematic equity risk. Adding more stocks cannot reduce that, because every equity carries it. The way forward is to change the mix of asset classes, since high-quality bonds respond to different forces and generally move less than stocks. That lowers total volatility at the cost of some expected return, which is the trade-off every allocation decision makes.

Three companies in a fifty-stock portfolio buy a critical component from the same supplier, and that supplier fails. The three fall sharply while the rest of the portfolio holds steady. How is the exposure classified?

1. A.Systematic, because one event affected several companies at the very same moment.Wrong. Affecting several companies is not the test; what matters is whether the other holdings escape.
2. B.Systematic, because disruption to supply chains is an economy-wide phenomenon.Wrong. This particular disruption was confined to one supplier's customers rather than the whole economy.
3. C.Nonsystematic, but only because the three companies sat in different industries.Wrong. Industry membership does not settle it, and the same reasoning would apply within a single industry.
4. D.Nonsystematic, because the rest of the portfolio was untouched by the failure.Correct. Forty-seven holdings were unaffected, which is exactly what an exposure diversification dilutes looks like.

Why: The test for classification is whether an investor could have held other things and avoided the event. Here the failure reached three companies linked by a shared supplier and left the remaining forty-seven alone, so the portfolio absorbed only a fraction of the damage. That makes it nonsystematic even though more than one company was affected. Had the failure been of a utility or a payment system every business depends on, no allocation would have escaped and the classification would change.