Which statement about diversification in Modern Portfolio Theory under ERISA is most accurate?

Which statement about diversification in Modern Portfolio Theory under ERISA is most accurate?

• A. Diversification is optional and often ignored
• B. Diversification reduces the risk of large losses
• C. Diversification guarantees higher returns
• D. Diversification eliminates market risk

Answer: (B)

Diversification reduces the risk of large losses by spreading investments across assets that don’t move in perfect harmony. In Modern Portfolio Theory, mixing assets with lower or negative correlations lowers overall portfolio volatility and helps cushion big losses from any one investment. This works because errors or shocks to a single security or sector don’t all hit at once when you hold a blend of assets. In the ERISA context, fiduciaries are expected to diversify to manage risk prudently, aiming to avoid excessive concentration while balancing cost and return. But diversification cannot guarantee higher returns, and it cannot eliminate market-wide risk that affects most assets at once. Even a well-diversified portfolio can suffer during broad downturns. So the key idea is that diversification reduces the chance and magnitude of big losses from idiosyncratic factors, while acknowledging that market-wide risks and the possibility of lower overall returns remain.

Diversification reduces the risk of large losses by spreading investments across assets that don’t move in perfect harmony. In Modern Portfolio Theory, mixing assets with lower or negative correlations lowers overall portfolio volatility and helps cushion big losses from any one investment. This works because errors or shocks to a single security or sector don’t all hit at once when you hold a blend of assets.

In the ERISA context, fiduciaries are expected to diversify to manage risk prudently, aiming to avoid excessive concentration while balancing cost and return. But diversification cannot guarantee higher returns, and it cannot eliminate market-wide risk that affects most assets at once. Even a well-diversified portfolio can suffer during broad downturns.

So the key idea is that diversification reduces the chance and magnitude of big losses from idiosyncratic factors, while acknowledging that market-wide risks and the possibility of lower overall returns remain.