Question

Your client has $100,000 invested in stock A. She would like to build a two-stock portfolio by investing another $100,000 in either stock B or C. She wants a portfolio with an expected return of at least 13.5% and a low a risk as possible, the standard deviation must be no more than 30%. What do you advise her to do (Rationalize your answer), and what will be the expected return and deviation of the recommended portfolio? (Please Show Calculations).

	Expected Return	Standard Deviation	Correlation With A
A	15%	40%	1
B	12%	30%	0.4
C	12%	30%	0.5

Answer 1

Expected return of stock B and stock C is equal and standar deviation of both stock is equal. So, hge should select based on lower correlation coefficient. So he should select stock B, because stck B has lower correlation coefficient with stock A.

Expected return of stock A is 15% and expected retrun of portfolio must be equal to 13.50%. So if he invest 50% in in stock A and 50% in stock B.

Expected return = (50% × 15%) + (50% × 12%)

= 7.50% + 6.00%

= 13.50%

Expected return of portfolio is 13.50% and weight of stock A is 50% and weight of stock B is 50%.

Now, Standard deviation of portfolio is calculated below:

Standard deviation of portfolio is 29.41%.