Investor #1 is anxious about the level of risk in her portfolio based on a recent period of increased equity market volatility. Most of her wealth is invested in a diversified global equities portfolio. Investor #1 contacts two wealth management firms, Investment Firm #1 and Investment Firm #2, for advice.
In conversation with each adviser, she expresses her desire to reduce her portfolio's risk and to have a portfolio that generates a cash flow stream with consistent purchasing power over her 15-year investment horizon. The correlation coefficient of Baker's diversified global equities portfolio with a diversified fixed-coupon bond portfolio is -0.10 and with a diversified inflation-linked bond portfolio is 0.10. The correlation coefficient between a diversified fixed-coupon bond portfolio and a diversified inflation-linked bond portfolio is 0.65. 

The adviser from Investment Firm #1 suggests diversifying half of her investment assets into nominal fixed-coupon bonds. The adviser from Investment Firm #2 also suggests diversification but recommends that the Investor invest 25% of her investment assets into fixed-coupon bonds and 25% into inflation-linked bonds.
Evaluate the advice given to the Investor by each adviser based on her stated desires regarding portfolio risk reduction and cash flow stream. Recommend which advice the Investor should follow, making sure to discuss the following concepts in your answer:

a Diversification benefits
b Cash flow benefits
c Inflation hedging benefits

Answer rating: 100% (QA)

Both Investment Firm 1 and Investment Firm 2 have suggested diversifying the Investors portfolio to reduce risk and generate a consistent cash flow st... View the full answer