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

question 61

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:

Average Cost Curve

A graphical representation that shows how the cost per unit of production varies with the quantity produced.

Scale of Production

Refers to the level at which a manufacturing process operates, which can impact the efficiency and cost per unit of production.

Average Costs

The total costs (fixed and variable) divided by the total output, indicating the cost per unit of output produced.

Decreasing Returns to Scale

A situation in which, when the scale of production is increased, the output increases at a proportionally lower rate.