An investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The investor is highly risk averse and has asked for your advice. The three stocks currently held in the portfolio all have Beta = 1.0. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium [neither over- or under-valued], and are equally correlated with the market, with correlation coefficient r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to the portfolio, or does the choice not matter?   Stock A since its Beta is lower. Stock B since its Beta is lower. Neither A nor B, as neither has a return sufficient to compensate for risk. It does not matter whether A or B is added, since both will reduce the portfolio’s risk by the same amount. There is not enough information to determine which stock would reduce portfolio risk by a greater amount.

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
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23 - An investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The investor is highly risk averse and has asked for your advice. The three stocks currently held in the portfolio all have Beta = 1.0. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium [neither over- or under-valued], and are equally correlated with the market, with correlation coefficient r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to the portfolio, or does the choice not matter?

 

  1. Stock A since its Beta is lower.
  2. Stock B since its Beta is lower.
  3. Neither A nor B, as neither has a return sufficient to compensate for risk.
  4. It does not matter whether A or B is added, since both will reduce the portfolio’s risk by the same amount.
  5. There is not enough information to determine which stock would reduce portfolio risk by a greater amount.

 

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