Using figures, comment on the statement - If two assets have the same expected rate of...

Using figures, comment on the statement - If two assets have the same expected rate of return but different variances, a risk-averse investor should always choose the one with the smaller variance no matter what other assets he holds.

P.s - the statement is false, so I need to explain why.

Expert Solution

Solution

Given that the investor is risk-averse and holds 2 assets that have the same expected rate of return but different variances

He/She should NOT blindly choose the one with the smaller variance because his portfolio IS NOT ONLY CONSISTING of only these 2 assets but also consists of assets belonging to other classes whose features i.e., risk / variances are different.

It is in accordance with the diversification principle

Calculation of expected rate of return

The expected rate of return is arrived at by taking the inputs of the probability of occurance of an event.

Ex: If there is 60% and 40% probability that the returns will be 10% and 5 % respectively then,the expected ate of return is :

= (.60 * 10 ) + (.40 * 5) i.e., 8%

Variance is a measure that describes the amount of deviation of the actual return from the expected rate of return (as calculated above)

As it is said that the past performance does not guarantee future performance,there is a chance that the variance may change in the future.

Rahul Sunny answered 1 year ago

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Using figures, comment on the statement - If two assets have the same expected rate of...

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