The correlation between Stock A and Stock B is 0.40. The correlation between Stock A and Stock C is 0.20, and the correlation between Stock B and Stock C is 0.25. All else the same, which of the following portfolios will have the least risk?
A) All invested in Stock A
B) All invested in Stock C.
C) Equally invested in Stock A and Stock B.
D) Equally invested in Stock B and Stock C.
E) Equally invested in Stock A and Stock C.

Question

Quizplus · Accepted Answer

To minimize risk, we want to choose a portfolio with the lowest overall correlation between assets. Since Stock A and Stock B have a higher correlation (0.40) than Stock A and Stock C (0.20) or Stock B and Stock C (0.25), we can eliminate options A and C.

Option B is investing all in Stock C, which doesn't take advantage of diversification.

Option D also doesn't offer the best diversification because Stock B and Stock C have a higher correlation (0.25) than Stock A and Stock C (0.20).

Option E is the best choice because it is equally invested in Stock A and Stock C, which have the lowest correlation (0.20). By diversifying across assets with lower correlations, we can lower the overall risk of the portfolio.

The Correlation Between Stock a and Stock B Is 0