Question

Stock A has an expected annual return of 24% and a return standard deviation of 28%. Stock B has an expected return 20% and a return standard deviation of 32%. If you are a risk averse investor, which of the following is true?

A. You would never include Stock B in your portfolio, as it offers a lower return and a higher risk.

B. Under certain conditions you would put all your money in Stock B.

C. You would never invest in either one of the two stocks.

D. For a low enough correlation coefficient between the returns of the two stock, you might want to invest in both.

E. I choose not to answer

Please give an explanation :)

Answer 1

Answer: D. For a low enough correlation coefficient between the returns of the two stock, you might want to invest in both.

A,B,C,E are incorrect.
Explanation:
If an Investor is a risk-averse investor then he hates volatility that is a standard deviation in the portfolio/stocks.

He will try his level best to decrease the volatility, even if it comes at a cost of lesser return.

If the correlation coefficient between two stocks is lower enough, that it creates a significant diversification benefit then the might invest in both the stocks.

Diversification means a reduction in the overall risk of the portfolio when 2 or more stocks are present in the portfolio. The overall risk of the portfolio is less than its weighted average risk of Individual stocks in the portfolio.

how can an investor have a diversified portfolio?

As per modern portfolio theory. There is a Benefit of diversification of risk when non-perfectly correlated stocks are added in the portfolio.

The benefit of diversification is when non perfectly correlated stocks are added then if the stock return of stock falls then it's offset by a rise in the stock return of another stock.