Consider a portfolio with a known average return and standard deviation. Which of the following stocks, if added to the portfolio, will reduce its risk through diversification?
A) A stock whose return is perfectly negatively correlated with the portfolio's return
B) A stock whose return is perfectly positively correlated with the portfolio's return
C) A stock whose return has zero correlation with the portfolio's return
D) Any stock added to a portfolio will reduce its risk regardless of its correlation with the portfolio

Question

Quizplus · Accepted Answer

A stock whose return is perfectly negatively correlated with the portfolio's return will reduce the portfolio's risk through diversification as its returns move in the opposite direction of the portfolio's returns. When one investment in a portfolio performs poorly, another investment performs well, and the overall portfolio risk is reduced.

Consider a Portfolio with a Known Average Return and Standard