7. Portfolio risk and diversification Aa Aa A financial planner is examining the
ID: 2821961 • Letter: 7
Question
7. 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 likely to have the smallest standard deviation? O A portfolio with 10 randomly selected international stocks A portfolio with 10 randomly selected stocks from U.S. and international markets O A portfolio with 10 randomly selected U.S. stocks Portfolio managers pick stocks for their clients' portfolios based on the investment objective of the portfolio and several other factors. One key consideration is each stock's contribution to portfolio risk and its statistical relationship with the portfolio's other stocks. Based on your understanding of portfolio risk, identify whether each statement is true or false. Statement True False The unsystematic risk component of the total portfolio risk can be reduced by adding negatively correlated stocks to the portfolio. Because of the effects of diversification, the portfolio's risk is likely to be more than the average of all stocks' standard deviations A portfolio's risk is likely to be smaller than the average of all stocks' standard deviations,O because diversification lowers the portfolio's risk. Portfolio risk will increase if more stocks that are negatively correlated with other stocks are O added to the portfolio.Explanation / Answer
Smallest standard deviation will be for portfolio which has lowest correlation among stocks. A portfolio with randomly selected 10 stocks of US and international companies will be the one that will have least corelation amongst themselves and hence would be the most diversified portfolio or one with lowest standard deviation.
Answer: A portfolio with 10 randomly selected stocks from US and international markets
Choosing the true and false statements.
Statement 1 is True. Unsystematic risk or diversifiable risk is the component that can be reduced by adding negatively correlated stocks to portfolio. Higher the negative correlation, lower will be the unsystematic (or diversifiable risk) component.
Statement 2 is False. It is the other way round. A portfolio's standard deviation is likely to be lower than the standard deviation of individual stock.
Statement 3 is True. This is because the standard deviation of portfolio would also take into consideration the correlation between the stocks of portfolio and it is likely that the correlation would reduce the unsystematic risk.
Statement 4 is false. Negatively correlated stocks if added to portfolio reduce the portfolio risk.
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