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.

Question

Quizplus · Accepted Answer

When adding a new stock to a portfolio, the investor should choose the stock that provides the best risk-return tradeoff. In this case, both Stock A and Stock B have the same expected return and correlation with the market, but Stock B has a lower standard deviation of returns (8% compared to 12% for Stock A). This means that Stock B is less risky and therefore provides a better risk-return tradeoff than Stock A. Therefore, the investor should add Stock B to their portfolio.

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