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:

Foreign Aid

Financial or material assistance given by one country to another, often to help with development projects, disaster relief, or economic stabilization.

Private Investment

The expenditure by private sector entities on assets to increase their capacity or efficiency, as opposed to public or government investment.

Foreign Exchange

The trading of one currency for another or the conversion of one currency into another currency, crucial for international trade and investment.

Labor Productivity

A measure of economic performance that compares the amount of goods and services produced with the number of hours worked.