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

question 135

Multiple Choice

A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio,to form a 4-stock portfolio.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) 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.
• E) Add A,since its beta must be lower.

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Definitions:

Marginal Revenue

The extra revenue obtained by selling an additional unit of a product or service.

Upsloping Line

A graphical representation indicating positive correlation between two variables; as one variable increases, so does the other.

Demand Curve

A graphical representation showing the relationship between the price of a good and the quantity demanded by consumers, usually downward sloping.

Pure Competition

A market structure characterized by a large number of small firms, a homogeneous product, and easy entry and exit from the market.