ACCA Financial Management (F9) Certification Practice Exam

What is the primary focus of portfolio theory?

1. Maximizing individual investment returns

2. Minimizing unsystematic risk through diversification

3. Evaluating market efficiency

4. Predicting interest rate fluctuations

The correct answer is: Minimizing unsystematic risk through diversification

The primary focus of portfolio theory is indeed on minimizing unsystematic risk through diversification. This concept, initially developed by Harry Markowitz in the 1950s, emphasizes that investors can reduce the total risk of their portfolio by holding a variety of investments that are not perfectly correlated. Unsystematic risk, which is specific to individual securities, can be significantly reduced when an investor diversifies their holdings across different asset classes, industries, or geographical locations. By spreading investments, an investor avoids the negative impact that any single investment could have on the overall portfolio's performance. This approach is based on the principle that while some investments may underperform, others are likely to perform well, thereby balancing the overall risk and improving the potential return on the portfolio. Other focus areas mentioned, such as maximizing individual investment returns or predicting interest rate fluctuations, although important in their own right, do not capture the essence of portfolio theory. Similarly, evaluating market efficiency is a separate area that revolves around the pricing of securities and how information is reflected in market prices, rather than the management of risk through diversification. Therefore, minimizing unsystematic risk through diversification serves as the cornerstone of portfolio theory.