A mutual-fund company’s newsletter says, “A nicely-diversified portfolio consists of assets with low correlations.” The newsletter consists of a table of correlations among the returns on numerous classes of investments. For example, the correlation among municipal bonds and big-cap stocks is .50, and the correlation among municipal bonds and small-cap stocks is .21.
Rachel invests heavily in municipal bonds. She wants to diversify by adding an investment whose returns do not closely follow the returns on her bonds. Should she select big-cap stocks or small-cap stocks for this purpose? Explain your answer.
A. Rachel ought to select small-cap stocks simply because that has a much smaller correlation with municipal bonds than big-cap stocks
B. Rachel ought to select big-cap stocks simply because that has a much smaller correlation with municipal bonds than small-cap stocks
C. Rachel ought to select small-cap stocks simply because that has a much bigger correlation with municipal bonds than big-cap stocks.
D. Rachel ought to select big-cap stocks simply because that has a much bigger correlation with municipal bonds than small-cap stocks.
