Question

2. Portfolio risk and diversification A financial planner is examining the portfolios held by several of her clients. Identify which of the following portfolios is likely to have the smallest standard deviation: A portfolio with 10 randomly selected stocks from U.S. and international markets A portfolio with 10 randomly selected international stocks A portfolio with 10 randomly selected U.S. 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, which of the following statements are true? Check all that apply. The risk in a portfolio will increase if more stocks that are negatively correlated with other stocks are added to the portfolio The portfolio's risk is not the weighted average of the individual stocks' standard deviations. The market risk component of the total portfolio risk can be reduced by randomly adding stocks to the portfolio. 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.

Answer 1

Risk of a portfolio decreases with diversification. This is because with uncorrelated or negatively correlated investments, the returns of each investment are less likely to move together with the returns of the other investments. This results in lowering of the portfolio risk.

The first option is correct. A portfolio with 10 randomly selected stocks from US and international stocks is likely to have the smallest standard deviation because of the diversification benefit offered by investing in both US and international stocks, instead of investing only in US stocks, or only in international stocks.

Statement 1 is not true. This is because with negatively correlated investments, the returns of each investment are less likely to move together with the returns of the other investments. This results in lowering of the portfolio risk.

Statement 2 is true. Portfolio risk is not the weighted average of individual stock's standard deviations. This is because the effect of covariance/correlation between the stocks must be considered

Statement 3 is not true. The non-market, or unsystematic risk can be reduced, not the market risk

Statement 4 is true. Positive correlation means that the returns move together