Efficient Frontier

Adding an asset class that has low or negative correlation with the rest of a portfolio primarily does what?

1. A.It reduces the portfolio's overall volatility without necessarily reducing expected returnCorrect. Offsetting movements smooth the portfolio's value, and expected return remains the weighted average of the holdings.
2. B.It eliminates the portfolio's systematic riskSystematic, or market-wide, risk cannot be diversified away. Only unsystematic risk can.
3. C.It guarantees the portfolio will not lose money in a falling marketDiversification softens swings; it never guarantees against loss.
4. D.It raises expected return while leaving volatility unchangedThis reverses the effect. The reliable benefit of low correlation is lower volatility, not higher return.

Why: Correlation measures whether two holdings tend to move together. When a new holding does not move in lockstep with the rest, its ups can offset the others down moves, which lowers the swings in the portfolio's total value. Expected return is the weighted average of the pieces, so it does not have to fall. The clue is the phrase low or negative correlation.

Odile Brancusi's advisor plots the expected return and standard deviation of every portfolio that can be constructed from a given set of asset classes, producing a cloud of points, and then traces the upper-left boundary of that cloud. What does a portfolio that lies ON that boundary represent?

1. A.The portfolio with the highest expected return of any combination in the set.That is a single point at the top of the frontier, not what membership on the frontier means.
2. B.The portfolio with the lowest standard deviation of any combination in the set.That is the global minimum-variance portfolio, one anchor point on the curve, not the definition of the curve.
3. C.A portfolio whose returns are uncorrelated with the broad market.The frontier is built from expected return and standard deviation; correlation with the market is a separate idea.
4. D.The highest expected return attainable at that level of risk, and equivalently the lowest risk attainable at that expected return.Correct. That two-sided property is precisely what places a portfolio on the efficient frontier.

Why: The upper-left boundary of the feasible set is the efficient frontier. A portfolio on the frontier is efficient in the mean-variance sense: no other attainable portfolio offers a higher expected return at the same standard deviation, and none offers the same expected return at a lower standard deviation. The frontier is a whole curve of such portfolios, not a single point, so the investor still chooses among them according to risk tolerance.