Accredited Wealth Management Advisor Practice Exam

Based on correlation, which asset class provides the least diversification when added to U.S. large-cap stocks?

1. Commodities

2. Small stocks

3. Emerging market stocks

4. Bonds

The correct answer is: Emerging market stocks

When considering correlation as a measure of diversification in an investment portfolio, the asset class that provides the least diversification when added to U.S. large-cap stocks would indeed be emerging market stocks. This is because emerging market stocks often exhibit a high degree of correlation with U.S. large-cap stocks, particularly during periods of market stress or when there are global economic trends affecting both markets. When two asset classes are highly correlated, their prices tend to move in the same direction at the same time. Therefore, adding an asset with a high correlation to an existing investment does not significantly reduce overall portfolio risk, as the benefits of diversification are diminished. On the other hand, commodities, small stocks, and bonds tend to have lower correlations with U.S. large-cap stocks and can therefore provide more effective diversification. Commodities, in particular, can react differently to economic conditions, and small stocks might provide higher growth potential in certain market conditions while having different risk profiles compared to large-cap stocks. Bonds typically have negative or low correlation with equities, especially during economic downturns, thereby adding to diversification benefits.