Suppose each stock in the preceding portfolio has a correlation coefficient of 0
ID: 2759638 • Letter: S
Question
Suppose each stock in the preceding portfolio has a correlation coefficient of 0.4 (p = 0.4) with each of the other stocks. The market's average standard deviation is around 20%, and the weighted average of the risk of the individual securities in the portfolio of four stocks is 42%. If 40 additional, randomly selected stocks with a correlation coefficient of 0.3 with the other stocks in the portfolio were added to the portfolio, what effect would this have on the portfolio's standard deviation (sigma_p)? It would gradually settle at about 50%. It would decrease gradually, settling at about 0%. It would gradually settle at about 20%. It would stay constant at 42%.Explanation / Answer
Since the correlation coefficient is less than 0.50, it will reduce the standard deviation of the portfolio due to diversification benefit. This diversification benefit will be in terms of decrease in standard deviation. Therefore, option B is correct.