ECONOMICS
RISK AND RETURN
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Question
[CLICK ON ANY CHOICE TO KNOW THE RIGHT ANSWER]
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The standard deviation of the portfolio is less than each of the individual stock’s standard deviations.
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The standard deviation of the portfolio is less than the weighted average individual stock’s standard deviations.
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The expected return of the portfolio is always greater than the expected return of each of the stocks if they were held in isolation.
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None of the above
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Detailed explanation-1: -The answer is B. We can understand the answer by considering the simplest case with only two assets in a portfolio.
Detailed explanation-2: -Expert Answer. The correct response is that standard deviations (SD) can be smaller than the weighted average of the SD of the individual assets owned in that portfolio. SD is used to assess the investment’s volatility. It aids in measuring the investment’s risk and analyzing the return’s stability in the portfolio.
Detailed explanation-3: -Holding assets in a portfolio eliminates firm-specific risk factors because these factors tend to cancel each other out. Thus, the standard deviation of a portfolio is usually lower than the weighted average standard deviation. This is the main benefit of diversification.
Detailed explanation-4: -The answer is: b. The standard deviation of a portfolio can often be lowered by changing the weights of the securities in the portfolio.
Detailed explanation-5: -Including securities that are not perfectly positively correlated with each other will reduce the SD of the portfolio. The lower the correlations between two returns of assets in the portfolio, the lower the portfolio risk, and thus the higher the diversification benefits and vice versa.