1.) A highly risk-averse investor is considering adding one additional stock to

Question

1.) A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with 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 his or her portfolio, or does the choice not matter?

Explanation / Answer

As both stocks have same expected returns and correlation, decision to choose the better stock lies in the comparison of standard deviation of these stocks.

Hence, Stock B is a better option as it has a lower standard deviation which means which can get the same return for a much lesser risk.

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