Question

You have a market portfolio and the risk premium for holding it is 5% per year. rf = 5%. There are two new stock issues: A or B. A stock has a standard deviation of 40%, a beta of 0.5, and an expected return of 8.0%. B stock has a standard deviation of 30%, a beta of 1.0, and an expected return of 9.0%. If you can add at most one stock to your portfolio, which one do you choose?

Answer 1

Standard deviation of the stsock explains how the price of the stock fluctuate from mean price. The stock with higher Standard deviation is vey volitile and so investors sould consider this before opting the stock

Step 1 find out the return from each stock using Ke= Rf+beta(Rm-Rf)

Where ke is the expected retun

Rf is the risk free return

Beta indicates the change in the price of the stock in relation to the change in the market price.

Rm-Rf= is the risk premium

so

Stock	Rf A	Beta B	Rm-Rf C	B*C=D	expected return =A+D	Standard deviation
A	5%	0.5	5%	2.5%	7.50%	40%	Highly volatile
B	5%	1	5%	5%	10.00%	30%	Less volatile compared to A

Step 2 Comparing the expected return derived from above with the expectations given

Stock	expected return =A+D	Given expected return
A	7.50%	8%
B	10.00%	10%

Since the stock B is able to meet the expected return and also has less standard deviation  when compare to stock A so i will chose stock B