Mary is anxious about the level of risk in her portfolio because of a recent period of increased equity market volatility. Most of her wealth is invested in a diversified global equity portfolio.

She contacts two wealth management firms (Firm A and Firm B) for advice. In her conversations 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 Mary’s diversified global equity 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 Firm A suggests diversifying half of her investment assets into nominal fixed-coupon bonds. The adviser from Firm B also suggests diversification but recommends that Mary invest 25% of her investment assets in fixed-coupon bonds and 25% in inflation-linked bonds.

Evaluate the advice given to Mary by each adviser on the basis of her stated desires regarding portfolio risk reduction and cash flow stream. Recommend which advice Mary should follow, making sure to discuss the following concepts in your answer:

a. Diversification benefits

b. Cash flow benefits

c. Inflation-hedging benefits