Question

5. Over the last twenty years, the average return and standard deviation of returns of large cap value stocks are 8.5% and 15.2%, and the average return and standard deviation of returns of fixed income portfolio are 5.3% and 3.4%. Suppose that over the next year the expected returns and risks of the two asset classes will remain the same as what happened in the last twenty years. Further assume that you can invest in a riskless asset with 2% return over the next year (you can also borrow money with an interest rate of 2%). Suppose that you can invest in the risk-free asset, and either the large cap value stocks portfolio or the fixed income portfolio. Which portfolio will you choose and why?

Answer 1

The Standard Deviation of the portfolio is considered as the risk involved in investing in that particular portfolio.

In the given case:

• Large cap value stocks portfolio has the standard deviation of 15.2% and the average return on the same is 8.5%
• Fixed income portfolio has the standard deviation of 3.4% and the average return on the same is 5.3%

Thus, the fixed income security is giving almost 60% of the returns which Large cap stocks portfolio gives. But, the risk involved in the fixed income security is almost 1/5th of the risk involved in the Large cap stocks portfolio.

So, Fixed income security gives more stable returns vis-a-vis the risk involved in the portfolio. Hence, along-with the risk-free asset, investment can also be made in the Fixed Income portfolio, to earn a stable income at lower risk.