DIVERSIFICATION REDUCES A PORTFOLIO’S ACTIVE SPECIFIC RISK; THEREFORE, THE PORTFOLIO WITH THE LOWEST ACTIVE SPECIFIC RISK IS LIKELY TO BE THE MOST DIVERSIFIED

12. A is correct. Diversification reduces a portfolio’s active specific risk; therefore, the portfolio

with the lowest active specific risk is likely to be the most diversified. Portfolio 2 has the

lowest active specific risk of 25%. Therefore, Portfolio 2 is likely to be the most diversified.