Assume Stock A has a standard deviation of 0.21 while Stock B has a standard deviation of 0.10.If both Stock A and Stock B must be held in isolation,and if investors are risk averse,we can conclude that Stock A will have a greater required return.However,if the assets could be held in portfolios,it is conceivable that the required return could be higher on the low standard deviation stock.

Question

Quizplus · Accepted Answer

When investors can hold a portfolio of stocks, they can diversify their risk, and the overall risk of the portfolio will depend not only on the individual stock's risk but also on the correlation between the stocks. Therefore, the required return on the low standard deviation stock could be higher if it has a low correlation with other stocks in the portfolio. This is known as the diversification effect. However, if the stocks must be held in isolation, the stock with a higher standard deviation will have a higher required return due to its higher risk.

Assume Stock a Has a Standard Deviation of 0