Question

ane has a portfolio of 20 average stocks, and Nick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT?

a. Jane's portfolio will have less diversifiable risk and also less market risk than Nick's portfolio.

b. The required return on Jane's portfolio will be lower than that on Nick's portfolio because Jane's portfolio will have less total risk.

c. Nick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios.

d. If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Nick's.

e. The expected return on Jane's portfolio must be lower than the expected return on Nick's portfolio because Jane is more diversified.

I know the answer is C ca you explain why A,B,D and E are incorrect. Thank you in advance!

Answer 1

When you purchase a large number of stocks, the risk associated with a specific stock is lower.

Like if a person just had Amazon and Tesla and both the company defrauded he will lose all of his money but when a person has 18 other stocks like Apple and Wells Fargo which provide exemplary return then even if these two companies defraud, rest 18 of the stock will provide him a higher rate of return so, Nick portfolio will be having more diversifiable risk because he is having a lower number of stocks and he is exposed to firm specific factors

Market risk cannot be diversified and hence it will be equal for both the portfolios.

Expected rate of return will be also similar on both the portfolio because Capital Asset pricing model only account for systematic risk while calculating and it does not account for unsystematic risk so expected return will be similar for both the portfolios.

Correct answer will be option (C).