Question

3. Portfolio risk and diversification Aa Aa E A financial planner is examining the portfolios held by several of her clients. Which of the following portfolios is likely to have the smallest standard deviation? O O O A portfolio containing only Chevron stock A portfolio consisting of about 30 energy stocks A portfolio consisting of about 30 randomly selected stocks Portfolio managers pick stocks for their clients' portfolios based on the investment objective of the portfolio and several other factors. One key consideration is each stock's contribution to portfolio risk and its statistical relationship with the portfolio's other stocks. Based on your understanding of portfolio risk, identify whether each statement is true or false. True False Statement The market risk component of the total portfolio risk can be reduced by randomly adding stocks to the portfolio. A portfolio's risk is not equal to the weighted average of the individual stocks' standard deviations. When returns on Stock A increase, returns on Stock B also increase. In general, this would mean that Stocks A and B are positively correlated. The risk in a portfolio will increase if more stocks that are negatively correlated with other stocks are added to the portfolio.

Answer 1

A portfolio consisting of 30 randomly chosen stocks is most likely to have to lowest standard deviation as these stocks' correlation are expected to be negative and hence cancel out each other with respect to risks. A single firm increases the concentration risk while 30 chosen similar firms would be positively correlated.

1)

The market risk component of the total risk is called systematic risk and this risk cannot be effectively mitigated by diversification as the risks are inherent in the market as a whole and the entire stock portfolio would be affected by risks in the market. Answer is false

2)

A portfolio risk is the square root of combined weighted variances of individual stock and the correlation between the two stocks. Hence the statement is True

3)

If Both A 's and B's stock rise increase or decrease together, it essentially means the two stocks are positively correlated.

Answer is True

4)

If negatively correlated stocks are added in a portfolio, the overall risk of the portfolio would decrease as increase in one stock would decrease the other stock returns and vice versa thus decreasing the overall risk of the portfolio.

Answer is False