Your Friend Is Considering Adding One Additional Stock to a 3-Stock

question 141

Multiple Choice

Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio.She is highly risk averse and has asked for your advice.The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market.Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and 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 not matter?

• A) Stock A.
• B) Stock B.
• C) Neither A nor B, as neither has a return sufficient to compensate for risk.
• D) Add A, since its beta must be lower.
• E) Either A or B, i.e., the investor should be indifferent between the two.

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Definitions:

BAT Model

A theoretical framework for analyzing the behavior, attitudes, and techniques necessary for effective leadership or managerial performance.

Optimal Cash Position

The Optimal Cash Position is the ideal amount of cash that a company aims to hold for covering immediate transactional needs while minimizing holding costs, ensuring liquidity without forgoing potential higher returns from other investments.

Cash Surpluses

Excess funds that a business possesses after it has paid all expenses and liabilities, which can be used for investment, paying down debt, or other purposes.

Disbursement Float

The interval when funds are disbursed from a payer's account until the payee's bank credits the amount.