A highly risk-averse investor is considering adding one additional stock to a three-stock portfolio, to form a four-stock portfolio. The three stocks currently held all have b = 1.0 and a perfect positive correlation with the market. Potential new Stocks A and B both have expected returns of 15%, and both are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice matter?
A) either A or B, i.e., the investor should be indifferent between the two.
B) Stock A.
C) Stock B.
D) neither A nor B, as neither has a return sufficient to compensate for risk.

Question

Quizplus · Accepted Answer

The best choice for the risk-averse investor would be Stock B. This is because both Stock A and Stock B have the same expected return and correlation with the market, but Stock B has a lower standard deviation, indicating it is less risky. For a risk-averse investor, lower risk is preferable, thus Stock B is the better choice.

A Highly Risk-Averse Investor Is Considering Adding One Additional Stock