8. Portfolio risk and diversification Aa Aa A financial planner is examining the

Question

8. Portfolio risk and diversification Aa Aa A financial planner is examining the portfolios held by several of her clients. which of the following portfolios is tikely to have the smallest standard deviation? O A portfolio with 10 randomly selected U.S. stocks O A portfolio with 10 randomly selected international stocks O A portfolio with 10 randomly selected stocks from u.S. and international markets Portfolio managers pick stocks for their clients portfolios based on the investment objective of the portfoio and several other factors. One key consideration is each stocks contribution to portfolio risk and its statistical relationship with the portfolio's other stocks. Based of your understanding of portfolio risk, identify whether each statement is true or false. Statement True False When returns on Stock A increase, returns on Stock B also increase. In general, this wouidO mean that Stocks A and B are positively correlated. The market risk component of the total portfolio risk can be reduced by randomly adding stocks to the portfolio. The risk in a portfolio will increase if more stocks that are negatively correlated with otherO stocks are added to the portfolio, A portfolio's risk is not equal to the weighted average of the individual stocks' standard deviations.

Explanation / Answer

Part A:

Standard deviation is the Risk of a portfolio which can be reduced by adding stocks that are not highly correlated with each other.
In this question, Option C A portfolio with 10 randomly selected stocks from the US and the international markets are likely to have the smallest standard deviation, since the US and the international markets are not perfectly correlated and country-specific risk factors can be diversified.

Part B:
A) True in general if 2 stocks move in the same direction they are considered to be positively correlated.

B) False since the overall portfolio risk can be reduced by adding negatively correlated stocks in the portfolio.

C) False, by adding stocks that are negatively correlated to the existing stocks in your portfolio will reduce the unsystematic risk component.

D) True in a well-diversified portfolio the overall portfolio risk will be lower than the weighted average of stock standard deviation because of the effect of diversification that will reduce the overall portfolio risk.

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