Question

Consider the following scenario analysis:   

		Rate of Return
Scenario	Probability	Stocks		Bonds
Recession	0.2	-5	%	17	%
Normal economy	0.6	18		11
Boom	0.2	24		4

Assume a portfolio with weights of 0.60 in stocks and 0.40 in bonds.

a. What is the rate of return on the portfolio in each scenario? (Enter your answer as a percent rounded to 1 decimal place.)

b. What are the expected rate of return and standard deviation of the portfolio? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

c. Would you prefer to invest in the portfolio, in stocks only, or in bonds only? Explain the benefit of diversification.

Answer 1

Solution:

1) Expected Return of Stocks, Bond and Portfolio:

2) Calculation of Standard Deviation of Stocks and Bond :

• 

= 10.07174265

• 

= 4.118252056

3) Calculation of Covariance between Stocks and Bonds :

4) Calculation of Standard Deviation of Portfolio:

• 

=21.6256

5) Conclusion :

Investment decision depends on ones risk taking capability but it is safe to diversify the portfolio because keeping all the eggs in one basket is not safe. Adverse condition in one sector or market may does not impact the same way to the others sector or market thus by reducing our downfall in the investment value. As in the present scenario stocks provide us the maximum return but with maximum risk on the other hand bonds provide us minimum return with minimal risk while portfolio is in between. So, it is better to go with portofolio as it is the blend of both bond market and stock market.