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:

Hypotheses

Tentative explanations or predictions that can be tested through research and experimentation.

Theories

Unobservable constructs that are linked together in some logical way.

Observations

The action or process of closely monitoring or noticing something or someone, often to gain information.

Scientific Method

A systematic procedure of observation, measurement, experiment, formulation, testing, and modification of hypotheses.